Using synthetics to trade a directional spread

Discussion in 'Options' started by lescor, May 20, 2005.

  1. I want to establish a long position in the spread of LQD / IEF, on a 10x13 ratio, meaning long 1000 LQD for each 1300 IEF that I'm short.

    Because these etf's are high in dollar value and low in volatility, it would require a considerable amount of capital to put on a trade of say 3000 x 3900. I am wondering if the trade would play out the same if I did it using options.

    From my cursory understanding of synthetics, I would want to be long a call, short a put of LQD with the same strike and expiration and take the opposite in IEF (short call/long put). My question is how do I determine what is the best strike to use? It is a trade I would want to have on for a month or two, so I have been looking at september expiry. LQD pays a monthly dividend of .43 and IEF pays .27 monthly.

    I want to play the directional movement of the spread, not the stocks themselves.

    Any feedback would be much appreciated.
     
  2. Maybe a visual would help.

    Here is a chart of the spread, expressed as LQD - 1.3 IEF, and a chart of the two stocks. I want to be long the spread (long LQD, short IEF) for an anticipated move back to 0 over the next 2-3 months with a stop about -2.25.

    If I were trading the common it would tie up over half a million dollars in capital to put this trade on 3000x3900 shares, which is the size I want to do. I want to know if I can achieve the same result using synthetic positions, or if a different strategy would work better (someone recommended a long/short vertical call spread strategy). The objective is to approximate the return I can achieve with the common, but use much less capital. There are strikes at every dollar level on these stocks.

    I do not have an opinion, nor do I want to venture a guess, as to what direction the individual stocks will move. I only want to play the spread, looking for LQD to outperform IEF.

    Thanks in advance for any ideas.

    <img src=http://www.elitetrader.com/vb/attachment.php?s=&postid=752846>
     
  3. nitro

    nitro

    If you are going to be doing option strategies, there is nothing more fundamental than understanding the basics of exercise and assignment. You must be prepared for any contigency, especially if you're short options where you don't control the exercise feature.

    I assume the options on these are American? Also, I assume that shorting either LQD or IEF will get you interest. Finally I assume that the options settle into LQD and IEF shares and not cash. Also, it is important to be aware that what is talked about here will not automatically carry over to any underlying, as there are IRS rules for example that affect the 15% dividend tax rate.

    A Synthetic long position can be initiated by going long the ATM call and simulatenously selling an ATM put. The ATM call has a delta of +.50. The ATM put has a delta of -.50 but since you are short the delta goes to +.50. So the total position has a delta of +1, which is the "same" as long 100 shares of the underlying.

    A Synthetic short position can be initiated by going short the ATM call and simulatenously buying an ATM put. The long call has a delta of +.50, so shorting it gets you to -.50. The long ATM put has a delta of -.50. So the total position has a delta of -1, which is the "same" as short 100 shares of the underlying.

    One of the risks is assignment risk on DIM contracts before the ex-div date (as the underlying moves and the options move DIM or other "arbitrage" opportunities that may exist.)

    In particular, keep in mind that it can be optimal to exercise an American-style put before expiration, assuming your counter-party has the ability to collect interest on the cash generated from shorting LQD or IEF, so you have to keep an eye on your options for assingment particulary on ex day (and you may not find out of assignment until much later in the day.)

    Read the risks of options here:

    http://www.twenty-first.com/pdf/optionsdisclosure.pdf

    Please don't blame me if anything goes wrong with this position in any way. This is not advice on my part but an effort to help with your original question as best that I know and to get you going on it.

    If I wanted to see for myself, I would start out by using 1 lots to put on each (synthetic) option position, and then see how that synthetic position bahaves in relation to the dividend(s) and how well the movement with the underlying goes. I would also keep track of margin requirements by my clearing firm. Then increase size as I gain confidence that I got it right.

    nitro
     
  4. I would consider just buying ITM calls on LQD with a decent delta (say .6-.7) and ITM puts on IEF with a similar delta. If the spread goes your way, you profit, but you can also profit if one side or the other moves sufficiently enough, or if implied vol simply heats up. Dont short any options at all.