The Synthetic Diagonal: Replicating Diagonal Spreads with Stock and Options

For the advanced options trader, the concept of synthetic positions opens up a world of possibilities. A synthetic position is a combination of options and/or stock that replicates the risk/reward profile of another position. The synthetic diagonal spread is a effective example of this concept, allowing a trader to create a diagonal spread using a combination of stock and options. This can be advantageous for a variety of reasons, including tax purposes, or in accounts that do not allow for the trading of spreads.

The Concept of Synthetic Positions

The foundation of synthetic positions lies in the put-call parity theorem, which states that the price of a European call option implies a certain fair price for the corresponding European put option, and vice versa. By combining calls, puts, and stock in different ways, it is possible to create a position that has the same risk/reward profile as another position. For example, a long call can be synthetically created by buying a put and buying 100 shares of the underlying stock.

How to Construct a Synthetic Long Call Diagonal Spread

A synthetic long call diagonal spread can be constructed by combining a long stock position with a short call and a long put. The long stock position and the long put create a synthetic long call, which serves as the long leg of the diagonal spread. The short call serves as the short leg of the spread. The resulting position has the same risk/reward profile as a traditional long call diagonal spread.

How to Construct a Synthetic Short Put Diagonal Spread

A synthetic short put diagonal spread can be constructed by combining a short stock position with a long call and a short put. The short stock position and the long call create a synthetic short put, which serves as the short leg of the diagonal spread. The short put serves as the long leg of the spread. The resulting position has the same risk/reward profile as a traditional short put diagonal spread.

The Advantages of Using Synthetic Diagonals

One of the primary advantages of using a synthetic diagonal spread is that it can be more tax-efficient than a traditional diagonal spread. In some jurisdictions, the tax treatment of stock and options is different, and a synthetic diagonal may allow a trader to take advantage of more favorable tax treatment. Another advantage is that a synthetic diagonal can be created in an account that does not allow for the trading of spreads. This can be useful for traders who have restrictions on their accounts.

The Disadvantages and Risks

The main disadvantage of a synthetic diagonal spread is the increased complexity. The position involves more moving parts than a traditional diagonal spread, and it can be more difficult to manage. The risks are also greater, as the position involves a stock component, which can be subject to large and unpredictable price moves.

A Detailed Example

Let's consider a stock trading at $100. A trader who wants to create a synthetic long call diagonal spread could buy 100 shares of the stock, buy a 60-day 95 put, and sell a 30-day 105 call. The long stock and long put create a synthetic 60-day 95 call. The short 30-day 105 call is the short leg of the spread. The resulting position will behave just like a traditional long call diagonal spread.

By understanding the concept of synthetic positions and how to construct and manage a synthetic diagonal spread, advanced options traders can add another effective tool to their trading arsenal. While this strategy is not for everyone, for those with the experience and knowledge to use it effectively, the synthetic diagonal can offer a number of advantages over a traditional diagonal spread.