How to Use Options to Replicate a Futures Position
Kurt J. Eckhardt has been trading since 1982 when he began his career as an active floor trader in the CBOT Treasury Bond pit. Kurt is President of Eckhardt Research and Trading and its subsidiary Agility Trading. Agility offers both individuals and funds cutting edge technical strategies along with high performance instruction. For more information go to www.agilitytrading.com or email Kurt at kurt@agilitytrading.com.
We’ve all been in the following situation. You find yourself bullish on a particular market but unsure if your secondary support will hold. If we give the trade enough room to survive a test of our primary support we may wind up taking a larger-than-normal loss. If we don’t enter a long position, we may miss an explosive move altogether.
Every now and then an opportunity presents itself that begs for us to be positioned. In these instances, the construction of a synthetic long, using a combination of options, can be a very useful tool.
A synthetic is merely an options trade that replicates a futures position. Normally defined, a synthetic long is the simultaneous purchase of an at-the-money (ATM) call and the sale of an at-the-money put. A normal synthetic behaves exactly like a position in the underlying.
For our purposes, we are going to build a synthetic long using options out-of-the-money (OTM) so that we may reduce our ATM exposure to moderate price swings.
Think of this trade as a naked collar. We are financing the purchase of an OTM call with the proceeds from the sale of an OTM put. Unlike with a collar, we hold no optionable position in the underlying.
As you should know, an ATM option has a delta of 0.5. That is, there’s a 50% chance the option expires either in or out of the money. Deferred strike prices thus have smaller deltas – that is, less sensitivity to changes in the underlying futures price.
Let’s illustrate with this hypothetical:
If in this case, if we buy a 4.60 call for the same price that we sell a 4.00 put (futures in this example are equidistant from each of our strikes) we will have spent little or nothing in premium.
However, we will have a position that at this moment behaves like half a future, and the synthetic will be margined at a rate commensurate with its delta exposure. Simply stated, the long 460 call will act like a quarter future and the 400 put will act like another quarter future. At expiration (whatever option month you choose), both options will be worthless if futures close between a range of 4.00 and 4.60. I call this a “no action zone.â€
We give up the potential profit of a move from 4.30 to 4.60 in exchange for not having to take a loss if the market closes between 4.30 and 4.00.
Because options trade continuously just like the underlying futures, a lower corn price before expiration will manifest itself as unrealized losses on your open options position.
Likewise, if corn rallies before expiration your mark-to-market trade equity will increase. It’s very important to not view synthetics as a method of circumventing either margin requirements or risk. Just because we have a minimal cash outlay doesn’t mean our position has less exposure on a large move than futures. Remember that if corn is trading below 4.00 at expiration, we will be assigned a long futures contract.
Our synthetic merely transfers some of our upside gains in exchange for minimizing our nearby downside. In fact, you can always buy a further deferred OTM put so that your downside is limited altogether.
The dynamic of a synthetic versus a straight futures long is the ability to smooth returns during those periods when the market chops at the in-betweens. On the big moves you enjoy unlimited upside gains while in turn limiting your ultimate long exposure to only those prices below the put you sell.
Although a synthetic can entail greater dollar risk than buying a vertical call spread, the chances of incurring any loss at all are lower with the synthetic. The great attribute of options is the ability for traders to pick any risk profile they feel appropriate.
Kurt J. Eckhardt has been trading since 1982 when he began his career as an active floor trader in the CBOT Treasury Bond pit. Kurt is President of Eckhardt Research and Trading and its subsidiary Agility Trading. Agility offers both individuals and funds cutting edge technical strategies along with high performance instruction. For more information go to www.agilitytrading.com or email Kurt at kurt@agilitytrading.com.