Synthetic positions and dividends

[KohPhiPhi]

Hello all!

There's a dividend-paying stock that I am looking to own, but I would rather own it via a synthetic long (buy a long-term ATM call and sell a long-term ATM pull).

My question in particular is about the dividend itself: as you hold the synthetic long, does the dividend get somewhat built into the options prices, or is it forfeited altogether?

Thanks!

 

[BlueWaterSailor]

My question in particular is about the dividend itself: as you hold the synthetic long, does the dividend get somewhat built into the options prices, or is it forfeited altogether?

Thought experiment for you: if it wasn't reflected in the combo, how many milliseconds would pass before some trader arbitraged the living hell out of it and retired on the proceeds?

P.S. Tony Saliba's "Managing Expectations" ( h/t @destriero ) covers similar arbs/synthetics. They're, uh, a bit thin on the ground in practice - and non-existent for retail as far as I can tell. In general, if you think you can see an obvious advantage in a trade, so can others - and they were here long before you, are always smarter than you, and have far more money and far less friction in trading than you. Obvious = wrong.

 

[KohPhiPhi]

Thank you for the response, BlueWaterSailor. I am not aiming to exploit any arbitrage. I am simply looking to learn how exactly future dividend payments reflect into the prices of the put+call forming the synthetic long.

Let me rephrase: when you own the stock, the dividends roll in every quarter so the benefit of owning said stock is clearly observed. So, when you own the synthetic position, how do the prices of the options adjust over time so the owner of said synthetic position benefit in an equal manner?

 

[BlueWaterSailor]

Thank you for the response, BlueWaterSailor. I am not aiming to exploit any arbitrage.

My point was not to instruct you in doing an arb; it's that if such an opportunity ever did exist, it would have been arbed away instantly. Therefore, it doesn't exist.

Let me rephrase: when you own the stock, the dividends roll in every quarter so the benefit of owning said stock is clearly observed. So, when you own the synthetic position, how do the prices of the options adjust over time so the owner of said synthetic position benefit in an equal manner?

Yep, that's a better question. It's called "basis", which consists of the cost of carry minus the dividends. This is why the equation for the future value of a stock consists of

FV = Price + Carry - Dividends

and the put/call parity equation is

Call - Put = Stock - Strike + Basis

 

[KohPhiPhi]

Thank you VERY much, super useful response.

Do I understand, then, that the dividend part of the "basis" is repriced every quarter, thus adjusting the prices of the call and the put overnight on the date the dividend is paid out?

Again, thank you for sharing your knowledge!

 

[BlueWaterSailor]

Thank you VERY much, super useful response.

Do I understand, then, that the dividend part of the "basis" is repriced every quarter, thus adjusting the prices of the call and the put overnight on the date the dividend is paid out?

Again, thank you for sharing your knowledge!

I'm not super-privy to the actual mechanics, but I've heard we have these things called "computers" nowadays that can calculate things on the fly...

Seriously, though: there's lots of moving parts to this stuff, and getting buried in the details is for specialists who can borrow a couple of hundred mil, run a quick trade, and pay it all back (or nerds like me who just love learning this stuff for its own sake.) For us retail guys trying to make money, though, it really is best to look in better-lit corners for opportunities.

If you're interested in synthetics, I recommend Saliba and Cottle. Both are outstanding.

 

[KohPhiPhi]

Thank you BlueWaterSailor, I appreciate the contribution.

 

[FreeGoldRush]

if it wasn't reflected in the combo, how many milliseconds would pass before some trader arbitraged the living hell out of it...

Best answer ever.

 

[KohPhiPhi]

Upon a bit more of research on the topic, it seems like the only difference between owning a stock downright vs owning its synthetic (long call + short put + bond) is the tax treatment.

At first I thought that the synthetic would win out as it requires a lower capital outlay, but it's not quite so: firstly, your broker might require some margin allowance to cover the naked put, and on top of that you'll need to use up the rest of the capital to purchase Govt bonds to yield the interest rate, since interest rates (and dividends) are already baked into the option prices.

So... unless I got it wrong, the choice is not about performance, but rather about choosing whichever way is more tax efficient for you, and whichever way you find more convenient to manage.

 

[earth_imperator]

It's all explained here:
"
Understanding How Dividends Affect Option Prices

The payment of dividends for a stock impacts how options for that stock are priced. Stocks generally fall by the amount of the dividend payment on the ex-dividend date (the first trading day where an upcoming dividend payment is not included in a stock's price). This movement impacts the pricing of options. Call options are less expensive leading up to the ex-dividend date because of the expected fall in the price of the underlying stock.

At the same time, the price of put options increases due to the same expected drop. The mathematics of the pricing of options is important for investors to understand so they can make informed trading decisions.

[...]"

Much more info in the rest of the above linked text...