Financial engineering
The idea of financial engineering is fairly new, and the concept of financial engineering extends the basic ideas of risk management in finance. The engineering metaphor highlights the specialized nature of the financial structure that can be created to manage particular types of risk. Calls, puts, futures, and other derivatives are the building block for financial engineering.
It is a process of selecting derivatives instrument to create some kinds of specialized products. A financial engineer selects from the wide array of puts, calls, futures, and other derivatives in the same way that a cook selects ingredients from the spice rack or a chemist mixes compounds in the laboratory to create new product.
Creating the synthetic instrument is the example of financial engineering through which the financial engineer creates a product that has different risk return profile (or feature) other than individual put and call possess. For example, the combination of a long call option and a short put option create a instrument called synthetic long which has equivalent risk return profile to taking long position in stock.
Portfolio Insurance
Portfolio insurance is an investment strategy designed to keep the investment portfolio from losing value in a downturn. In another word portfolio insurance is the strategy of protecting the value of portfolio from downside risk. Most portfolio insurer employs various kinds of hedges to protect a portfolio’s value. Before entering into more sophisticated portfolio insurance strategy let’s start from a simple strategy.
Stop-loss order
The stop loss order provides a simple but imperfect form of portfolio insurance. It is an order to broker by the holder of securities to liquidate the securities if the market price of securities fall to the level specified in the stop-loss order.
The broker execute the order immediately if the market price of the securities fall to the specified level without consulting to client once after getting the instruction (i.e. stop-loss order)
In this way, the order stops the downside risk (i.e. loss). However, it is not a perfect approach to insure the value of portfolio because if the decline in the price of securities is temporary in nature the holder of portfolio may loss more reacquiring same portfolio in the later date.
Buying a protective put
It is more dependable form of portfolio insurance where the values of the securities containing in the portfolio are protected against the downside risk by buying put options. With this strategy the value of portfolio insured equals to the value of exercise price (or strike price) less put premium at which puts are purchased. What value of portfolio a portfolio manager can insured depends upon the availability of put options their purchase price and strike price.
Strategies involving a single option and a stock
There are a number of different trading strategies involving a single option on a stock and the stock itself.
The portfolio consists of a long position in a stock plus a short position in a call option. This is known as writing a covered call. The long stock position covers or protects the investor from the payoff on the short call that becomes necessary if there is a sharp rise in the stock price. The reverse situation can be created by taking short position in a stock in combination with a long position in a call option.
Another popular investing strategy involves buying a put option on a stock and the stock itself. This approach is popularly known a protective put strategy. This strategy protect the investor from downside risk i.e. it insure the value of security at a price equal to exercise price less put premium.
Synthetic position/ synthetic instrument
Each of the three distinct financial instruments; calls, puts and the underlying stock has a unique risk/reward profile. An investor may enter and exit a long or short position in any of them without involving the other two instruments
Still, each of these instruments is connected to the others in an interesting way, creating a triangle. By correctly combining any two of them, the investor can create a so-called "synthetic position (or instrument) that copy the risk/reward profile of the third.
In another words, A financial instrument that is created artificially with the combination of other different financial instrument is called synthetic instrument.
For example, we can create a synthetic stock by purchasing a call option and simultaneously selling a put option on the same stock. The synthetic stock would have the same capital-gain potential as the underlying security
Synthetic long position (synthetic long stock)
An option trader who simultaneously writes (or sells) a put and buys a call option on the same underlying security having same exercise price create a position this is like owing (holding) a long position in the underlying stock. In another words, buying a call and selling a put on the same security create a synthetic long position in the optioned security that is similar to buying and holding the stock in ordinary way.
The synthetic long position may be more desirable than a straightforward long position on the stock because the synthetic position requires less margin investment and thus provides more financial leverage. Undesirable features include the margin requirement to write the put. Furthermore, the owner of a synthetic long position does not collect cash dividends or coupon interest from the underlying securities. The final undesirable feature of the synthetic long position is that when the potion expires, additional option premium must be paid to recreate the same synthetic long position.
Synthetic short position (synthetic short stock)
An option trader who simultaneously writes (or sells) a call and buys a put on the same underlying stock having same exercise price creates a position equivalent to short position (or selling) in the stock. In another words, buying a put and selling a call on the same stock create synthetic short position in the optioned security that is similar to selling short the stock.
A synthetic short position is more desirable than a traditional short position for three reasons. First, the option position is superior because the call that was sold should bring in more income from its premium than is spent to pay for the premium on the long put. Second, the synthetic short sale offers more leverage because traditional short selling requires more initial margin of about 50%. The synthetic short position involves a smaller initial investment as shown below.
Deposit : 15 % of the optioned stock’s price
Add : the call premium proceed from sale
Less : the put premium paid
Total : an amount that is less than 50% initial margin of short position (short selling)
The third benefit is that the synthetic short seller does not have to pay cash dividends on the optioned stock as the short seller would on the borrowed stock. The only disadvantage inherent in any option position is that option expires and more frequently money must be spent for option premium to reset up the position.
Synthetic long call (buying a put/ protective put combined with underlying)
Suppose a bullish stockowner becomes worried about the equity's short term prospects but is reluctant to sell the stock immediately. This investor can create a synthetic long call simply by buying a put (this is also known as the protective put strategy) the upside is still virtually unlimited, but the risk on downside is capped for the term of the option.
With the synthetic long call the stockholder or stock buyer can limit the downside risk inherent in underlying stock. This strategy looks equivalent to the long call position.
And this strategy is appropriate to use in bullish to very bullish market.
Synthetic short call (short put plus short stock)
A short put position combined with a short stock position create a strategy with limited profit potential if the underlying stock price decline and unlimited risk if rise.
The maximum profit is obtained if underlying is anywhere below the strike price of the put at expiration. If underlying rallies, losses start at the breakeven point and increase, the higher the stock moves. This position looks like a short call position at the expiration.
Synthetic long put
If an investor has a short position in underlying and would like to limit the risk, a long call position can be added to cap losses from a possible increase in the underlying
As long as the call is owned or until it expires the short seller has created a position with limited risk (if underlying increases) and substantial profit potential (if underlying declines).The potential is limited only by the fact that the stock price cannot fall below zero. Also the call premium reduces the potential gain
The risk reward profile for the combined position looks like of a long put at expiration.
Synthetic Short Put
The synthetic short put, also known as covered call, can be created with the combination of short position in call and a long position in underlying stock. This produces a risk-reward profile that limits the profit potential and substantial downside risk that is equivalent to taking short position in put option. Thus it is known synthetic short put.
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