Synthetic Options

[Hardy Noman]

Hi,

I was researching on options and found some really good information on this website, I was wondering if option payoffs can be synthetically achieved.
I would appreciate if you could help me solve the following Query.

Can we replicate option payoff by using Futures?

Eg. if an index is currently at say , 1000 & the nearest Index future (Current month future contact) is at say, 1010.
I am expecting the Index value to decrease in future, for which if I were a option trader, I would have purchased a Put Option at Strike of say, 1000. At premium of 25 Per option.

Instead of doing this. Cant I sell a future at 1010 and put a stop loss at say 1011
(so maximum loss of only 1 compare to option cost of 25)

Case 1 (INDEX ROSE IN VALUE at Future expiry)
incase the index future rose to 1030, my Index future position would have squared off at 1011 (with loss of 1),
Where incase of Put, I would have lost 25

Case 2 (INDEX FELL IN VALUE at Future expiry)
Incase the index fell in value to 950, I would have profited 60,
Where incase of put my profit would be (50-25 = 25)

Case 3 (INDEX is same at Future expiry)
Since the index is stable at 1000, at expiry the future and spot would have equal values, Future value = Spot value =1000
Therefore profit of 10, where incase of put my profit would be (0-25=-25)

BEFORE EXPIRY MOVEMENT
After shorting the option, but before expiry, we can use automated trading (algo trading software) and put a formula so that once we short the future at 1010, with a stop loss of 1011, incase the future index value increases our position would square of at 1011, once our position is squared off at 1011, this will trigger a NEW Limit Sell order (since our original position was short) at 1011 or 1010, so incase the index future went up to 1030, but when it starts dipping our limit order would execute at 1011 or 1010, once our limit order is executed there shall again be a stop loss placed (automatically by the software) at 1011.
After this if the price is lower than 1011 at maturity of future, our payoff would be more than the PUT Payoff, but incase at maturity the future index is above 1011 our stop loss would have already trigged a square off transaction, thus limiting our lossed to 1 only.

While I think the only limitation of this strategy is the Transaction costs.

Please let me know are there any other technical shortcomings of this strategy
Also suggest any other synthetic options strategy, which can be used in markets where option contracts don’t exist.

Thanks a ton for going thru this!!!!!

 

[ShaktiRathore]

hi,
The other limitations of this strategy,
1. The put option does not expire once the futures value cross the threshold of 1011 but instead there is still some time left before the exercise of the option such that the option still ends up in the money when the futures price swings back below the 1000 level before the exercise of the option, so this is clearly an added advantage of put option over the just futures trading strategy. This suggest that extra gains from futures strategy is due to the risk of our synthetic option expiring worthless by an upward swing as compared to put option where both upward and downward swings are permissible before the expiration of the option and as such there is no such high risk of an upward swing as compared to futures only strategy so this extra risk makes up for added return.
There is time value associated with option value as compared to futures, so that even if the option is OTM now it has enough time left to become in the money but future is already expired so there is no time value here. If there is high volatility than its possible that with 50% chance that the swing is upward and future strategy is in loss but in put option with high volatility its still possible to come back to ITM position. so that put can be ITM or OTM with wild swings but one way swing will kill the futures position.
2. The futures are marked to market daily so that if there are profits on several days than the profit need to be invested at certain rates so that the futures profit are exposed to the reinvestment risk making them vulnerable to interest rates as compared to put option where there are no intermediate payments and only lump some so that there are no reinvestment risk as such. This added risk of futures as compared to put option further explains the added return for futures for bearing the risk.
3. As you said the added transactions costs can further add to the cost of trading in futures. We buy put once and pay the premium(1 transaction) while in futures strategy there are added transactions after initial Tx of shorting future ,1 of stop loss Tx + 1 transaction of taking offsetting positions so there are added cost due to this added transactions. This also makes up for extra return.


thanks

 

[Hardy Noman]

Thanks for the reply, Shakti.
Real Awesome points made there!

Incase of the synthetic strategy, if there are wild upward swings the position would square off at 1011,
but after some time, if the index starts to reverse and reaches 1010 from above, again a short order will be executed (with stop loss 1011).
this process would go on till expiration of the futures.
So just like the option even the synthetic strategy would benefit (apart from the transaction cost) from increased volatility.

This strategy is basically for Developing markets who have futures but not options,
& even for developing markets where options exists (but liquidity is very low).

Are there any other strategies to create a synthetic option?

Thank you!