Vertical Spreads and Synthetic Option Spreads: How Do They Work?
Options are investment tools that allow you to hedge against risks and multiply your potential returns. One can use them to bet on a stock’s price movement without the risks or expenses of owning it. However, to achieve such goals, traders need to have advanced knowledge of market movements and trading strategies.
There are many option trading strategies that traders can learn to mitigate risks and maximise returns. Two of them are the vertical spread strategy and the synthetic option strategy.
This blog will take you through these option trading strategies and what they help to achieve. Hence, keep scrolling.
What Is the Vertical Spread Trading Strategy?
A vertical spread is also called a credit spread. Option traders use this particular strategy to profit from a bullish price movement while mitigating risks. The strategy involves buying and selling an option of the same type (puts or calls) with the same underlying asset.
In vertical spread trading, investors use two options with different strike prices but the same expiration dates. By simultaneously buying and selling options, you take a long and a short position on the same security.
Vertical spreads can be either bullish or bearish. A bullish vertical spread strategy aims to earn profit from an increase in stock price maintaining low risk. On the other hand, bearish vertical spreads aim to profit from a decline in prices.
One can classify vertical spreads into two types- net debit and net credit. When traders purchase options beforehand, they make a net debit trade. On the other hand, when traders require to sell options upfront, it is net credit trade.
What Are the Types of Vertical Spread Strategies?
There are several techniques in vertical trading strategies. Following are two such relevant vertical trading methods that traders usually follow with vertical trading.
- A Bear Put Strategy
This is an options strategy where a trader anticipates a medium to a large price drop for a given security. Consequently, he/she chooses to lower the cost of holding the option contract. This strategy aims to purchase a put option at a high price and sell them at lower rates. Thus aiming to wait for the stock’s spot price to drop at or close to the bear put strike price.
- A Bull Call Spread
A bull call spread strategy is one where an investor purchases a call option and sells another at a higher strike price. They tend to use this strategy to reduce their losses or lower their gains. Their net premium outflow reduces and the premium on traded options also falls. This, as a result, reduces the loss for traders.
What Is the Synthetic Option Spread Strategy?
A synthetic option is a combination of call or put options with different underlying assets. Synthetic option strategy helps improve payoffs of other instruments with a mix of futures, cash positions and options.
For every asset, there is parity between the prices of calls and puts. Due to the relationship between prices, certain option positions are said to be more synthetic. Synthetic options are portfolios of different securities that replicate the position of another asset. Traders often create such options to reduce volatility and decay and adjust against existing positions.
When a trader creates a synthetic option spread, its opposite position carries cash or futures of the same value or size. Synthetic options can also restrict chances of unlimited risks that tend to emerge out of futures owing to unsafe hedging practices.
What Are the Types of Synthetic Options Trading Strategies?
Traders use synthetic options to recreate the risk profile and payoff of a certain option with a combination of various options and underlying instruments. They can minimise or eliminate several trading problems by opting for synthetic options. These options are less affected by adverse situations like expiration, volatility, and strike price. These factors do not affect the returns of synthetic options as much as affect regular options.
There are two types of synthetic options, these are synthetic calls and synthetic puts. Both of them require a combination of long and short positions and options.
How Do Synthetic Call Options Work?
A synthetic call is a trading strategy that goes for stock shares and put options to improve the call option’s performance. This strategy does not directly use a call option, hence the name synthetic long call option. It is also called the protective put or married put option.
A synthetic call option has a long position in the underlying instrument combined with an at-the-money put option. This strategy helps an investor stay in a bullish position as opposed to a downward market movement.
Both synthetic calls and long calls have the potential for unlimited profits as the price of their underlying asset rises. However, it is important to note that an investor’s profits are decreased by the premium paid for purchasing options. At a break-even point when prices of underlying stocks rise by the amount of premium paid, an investor makes a profit.
Synthetic call options are more of a capital-preserving strategy than profit making strategy. Here, the cost of purchasing options reduces the profitability of this strategy, making underlying stocks move higher than their desired directions. As a result, this strategy helps investors as a hedging move to cushion against huge losses.
How Do Synthetic Put Options Work?
This options strategy combines a short stock position and a long call strategy to work as a long put trading option. It helps investors protect themselves from appreciation in a stock’s price. This strategy is also known as a protective call or a married call option.
Synthetic put options come in handy when an investor marks a lower strike price but the market reflects an upward movement of prices. This strategy helps an investor profit from a bearish market trend. As a result, synthetic puts eliminate the potential risk of losses when the prices of stocks tend to increase.
A synthetic put strategy involves a short position for underlying stocks. Consequently, it also attracts all associated risks that include the possibility to pay dividends, fees and margin interest rates when they purchase shares and sell short.
Furthermore, on certain securities, institutional investors tend to use synthetic puts to cover their trading bias for particular securities. However, regular investors tend to use them like insurance against market volatility. Time decay or expiration will negatively affect the impact of this trading strategy.
This blog has presented everything you need to know about the two option trading strategies- synthetic options and vertical spreads. You can study other strategies and decide which one suits your investment goals. As options trading includes the chances of huge financial losses, you should assess if you have the risk appetite for it.
Frequently Asked Question
What are the best options trading strategies?
Here is a list of some of the best option trading strategies that traders should be aware of before starting with options trading.
Bull call spread
Bear call spread
Bull put spread
Bear put spread
Bull call ratio back spread
What are some intraday options trading strategies?
Following are some of the popular intraday option trading strategies.
Gap go-ready strategy
Moving average crossover strategy
When should an investor use a protective long-put strategy?
Traders with a bearish approach to the market can use a protective long-put strategy. This strategy cushions traders from major losses when the market moves opposite to their expectations.
What is the formula to calculate put-call parity?
The equation to calculate put call parity is as follows:
C+PV(x) = P+S
Here, C= Price of a European call
PV(x) = present value of strike price (x) discounted from expiration date at a risk-free rate
P= price of European put
S= spot price of an underlying asset