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American Options, European Options Synthetic Options
American Options, European Options & Synthetic OptionsThe Smart Profits Report: Issue #122
Monday, June 28, 2004
American Options, European Options & Synthetic Options: Threefold Profit Potential
By Karim Rahemtulla
Investment Director, Mt. Vernon Research
At a conference many years ago, an audience member asked me a question about options types. That was a first. As far as I was concerned, back in my uneducated days, there was only one type of option: the one that lost you money!
In the years since then I have learned better. There are many types of options. Most fall into three categories, which are: American options, European options & Synthetic options.
And knowing the difference between the three will put you at a major competitive advantage over options traders who don’t.
Let me explain…
American Options, European Options - Vive la Difference
American options can be exercised any time the option is valid. In theory this means that the option can be converted into the shares at any time until the option expires. This doesn’t happen often, though, since most traders are in the market to trade options rather than convert them into stock… that would mean actually having money in your account to buy the shares! Stock options, versus index options, are American-style contracts - you can exercise any time. (Same with most futures options.)
The European-style option can only be exercised on a specific date - almost always on the expiration date.
Most index options are European-style options. One exception is the first index option traded in the United States, the OEX contracts for the S&P 100. These are American-style options, but there is also a related European-style index for the S&P 100, the XEO.
Other index options - such as the DJX (for the Dow Jones Industrial Average), the SPX (S&P 500), OIX (CBOE Oil Index) and NDX (Nasdaq 100) - are European-style options.
Even if you can’t exercise a European-style contract early, you can still trade in and out at any time, just as you would with your American-style stock options.
Synthetic Options - A Third “Style”
Another “type” of option is a synthetic option. When the definition of this type of option was asked of me at a Palm Beach Chapter meeting in the mid-1990s, I could not answer it.
Fortunately, I do not get embarrassed in public very often. And when it happens, I have found that humor and humility are perfect bedfellows. Of course, within a few hours I found time to learn a little about synthetic options.
A synthetic option is created by a combination of two options or an option and shares. It is “synthetic” because the two instruments being “synthesized” - put together - have the same effect as a different investment. It’s the proverbial “another way to skin a cat” when it comes to trading options.
Here’s an example: A synthetic long call is created by holding a long position in a stock and buying a put on it at the same time. It is the equivalent of buying a call (that’s why they call it a synthetic long call). This is also known as a protected long.
The “Protected Long Strategy,” and How It Can Save You
You can mimic shorting a stock with a synthetic short stock, which involves no stock at all. It’s made up of a short call and a long put.
Why would one engage in a synthetic play? Maybe you can guess why with the synthetic long call example (long 100 shares of stock and long one put) that I just gave.
Suppose the stock you are interested in is a highly speculative position. You think it can go up big time, but there’s more than the usual risk that it could fall a lot instead. With a regular call, if the stock drops, your call goes down. End of story. You lose.
With your synthetic call, if the stock drops, your put is there to protect you. You can exercise your right to sell the shares at the put price, executing your hedge and inuring your portfolio.
Good trading,
Karim Rahemtulla
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Today’s Smart Profits Crib Sheet
- Visit the Smart Profits Glossary for further definitions of options terms such as “synthetic option“, “American option” or “European option.”
Related Articles:
- Options Leverage - How to Use Delta to Maximize Leverage
- Options On ETFs: Increased Safety and Profit Potential
- When to Buy the Stock - And NOT the Option
