Understanding
Stock Options Trading
and Technical Analysis Basics

Call and Put Synthetics (Risk Reversals)

A synthetic trade - sometimes also called a Risk Reversal - involves buying a call and selling a put with the same strike price and expiration date or vice versa depending on your outlook for the stock. A Long Synthetic is the name for the bullish trade option, where a call is bought and a put is sold.

The effect of these call and put synthetics is similar to just buying a basic call option, where your profits are unlimited the higher the stock climbs. However, there are a few key differences. Firstly, a long synthetic requires you to sell a put option. Doing so means you will need to close this position before expiration to prevent the put option being exercised.

As can be seen in the chart below, buying a basic call option means that the maximum you will lose is the premium of that call. However, you won't start to see profits till the stock climbs a bit higher than the strike price of the option. In a long synthetic, selling a simultaneous put option changes both these characteristics.

Long synthetic individual components

Long synthetic composite

By combing the profit charts of the call purchase and put sale, it can be seen that the potential loss of the trade has become unlimited. In a basic call option, the maximum you will lose is the premium you spent buying that call. In a long synthetic however, you have an open put option which you will need to buy back before expiration, and that put option will cost more the lower the stock price becomes.

However, with this extra risk comes couple of key benefits. Firstly, because you are selling a put option (thus earning premium) together with buying a call, the long synthetic becomes cheaper than simply buying a call. In addition, by adding the profit charts of the call purchase and put sale together, you can see that this position starts to see a profit as soon as the stock goes over the strike price.

Easy-speak Call and put synthetics involve buying a call and selling a put at the same strike price, or vice versa. A long synthetic is a bullish strategy and involves buying a call and selling a put. It has unlimited profit as the stock price climbs, and unlimited loss as the stock price falls. Since options are sold, this position needs to be closed before expiration.

A Short Synthetic is basically the opposite of the long synthetic position. This is a strategy for when you are particularly bearish on a stock. You buy a put option while simultaneously selling a call option at the same strike price with the same expiration date.

Similar to the above scenario, if you had only bought a basic put option, you don't start seeing profit till the stock goes a bit below the strike price. On the other hand, a basic put will cost you the full cost of the put option's premium, and your maximum loss is that premium.

Conversely, a short synthetic allows you to see profit the moment your stock goes below the strike price, and the initial premium spent on the put option is offset by the amount made selling the corresponding call option. However, these advantages come with a big caveat: you now risk unlimited losses. If the stock keeps climbing higher and higher, the cost to buy back the call option before expiration will increase correspondingly, making this position very costly if you wrongly predict the direction of the stock movement.

Short synthetic individual components

Short synthetic composite

Easy-speak A short synthetic is a bearish strategy that involves buying a put option and selling the corresponding call option at the same strike price. You will see unlimited profits if the stock price keeps falling, but also suffer unlimited losses if the stock keeps climbing. Since options are sold in this position, it needs to be closed before expiration.

A lot of people think of synthetics as a cheap way of playing basic options, since the option premiums are offset by selling the opposite option contracts. However, please bear in mind that this position is similar to trading in futures. If you wrongly predict the stock direction, call and put synthetics can become very costly.


Other Topics in this Guide

Bullish Strategies Bearish Strategies Neutral Non-Volatile Strategies Neutral Volatile Strategies

Wiki Wiki

Home | Options Basics | Options Strategies | Technical Analysis | Resource Library | FAQ | About Us | | Facebook