trading methods - Long Option or Synthetic Option

One thought that crosses my mind when trading is that the 5 percent of the time that I am directional in my trading, Which long option strategy is the best in terms of practical risk and reward? Many of you are probably scratching your heads right now thinking that I might be off my rocker. For those of you who are novices there is 2 ways to construct a risk graph that looks like a long call option. The first is by buying a call option and the second is by creating what is known as a synthetic long option. This is done by buying the underlying and also buying a put for protection.

For example purposes lets say we are interested in a long strategy in the S&P 500. At the money calls and puts are each trading for 15 points. I can create the same risk graph by either buying the at-the-money call or by buying the futures and buying an at-the-money put. Does these two positions offer the same risk and reward. Lets examine the entry of each.

S&P = 900 and 900 calls and puts are both 14.50 bid and 15 ask each

• Example 1
  Long 1 S&P 900 call at 15 points
  Cost - $7500 + 1 commission
• Example 2
  Long Futures at 900 + Long 1 S&P 900 put at 15 points
  Cost - $7500 + 2 commissions

Example 1 looks like the logical choice because we only have 1 commission versus paying an additional commission for example 2. Why then do professional traders sometimes take a synthetic approach to trading rather than simply buying the call of the put. Well if the trader intends to hold the position and look for a big increase in his favor, the synthetic will in most cases, be the better strategy in the long run. Lets look once again at the example to find out why.

S&P is now at 925.	900 calls are bid 25 and ask 26
	900 puts are bid 1 and ask 1.15

In example 1 we can exit the trade buy selling the 900 calls for a price of 25 therefore capturing a profit of $5000 (12,500 - 7500)

In example 2 we can exit the futures side for a profit of $12,500 plus exit the put side by selling for 1 point and incurring a $7000 loss, thereby netting us a profit of $5500.

Example 2 now looks better due to less slippage and in this case, some time premium left over in the puts. Remember that volatility can play an important role in determining which strategy is more practical. Just some food for thought.

Good trading!