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Most investors are concerned about risk. Risk can take many forms. An analysis of stock market returns shows that big down moves of several standard deviations occur fairly often and they can be devastating to portfolios. The 1987 crash was a full 20 standard deviations from the mean. If stock market returns followed a normal distribution a move like that would be considered to be statistically impossible.

One problem with hedging against risk is the cost. If your portfolio performs well, the hedge cost can be a drag on your returns. Buying index puts is one common way to hedge, but they can be expensive. By using a synthetic position, you can hedge and put the initial position on for a credit, so there is no cost but there will be a margin requirement.

When using options the synthetic long stock is a combination of a short put and a long call. It can be initiated for a credit, a debit or neutral depending on the strikes that are chosen. Anytime you work with options there are virtually unlimited combinations that can be used to produce the desired result. As an example here I'm going to illustrate a synthetic long stock on the SDS. The SDS is the ETF that is the ultra short the S&P 500 index. If the market falls, the SDS rises.

We'll sell a January 2013 59 put for $3.10 and simultaneously purchase a January 2013 63 call for $1.99. The position is put on for a net credit of $1.11. If the market stays flat between now and the January expiration, the whole position will expire worthless and you'll keep the $1.11. If you use a 10 contract position that's just over a thousand dollars, $1,110. If the market rises you're obligated to buy SDS at $59 by January 19th, so you'll want to have a defensive strategy in place if the market rallies. The right size to use for a trade like this depends on your unique situation. If used as a hedge, you may want to beta your portfolio to the S&P, then get enough contracts to cover your portfolio. So, if you have a $100,000 portfolio that has a beta of 0.80 you'd want to use about 12 contracts to match the dollar risk. The SDS is designed to move twice the inverse of the S&P on a daily basis, not over longer time frames. It will not track 2X the S&P over a 60 day or longer time frame, but if the market has a big down move in one day, the SDS will move up accordingly.

Currently the SDS has a 60 day statistical volatility about 23, the implied volatility of the puts is 32 and the implied volatility of the calls is 34. A ten contract position would have a delta of 826, so, at the onset it would be equivalent to owning 826 shares. The theta is $1.23, which means the time decay of the option position will be on your side. This position has a theoretical profit or expected return of $224. I suggest always using a pricing model and evaluating the expected return of your position and only initiate those positions that have positive expected return.

Since the position requires selling puts you should have a defensive plan in place in case the market rallies and the hedge is not needed. One thing you could always do is take assignment on the puts and buy 1000 shares of SDS at $59 minus the initial credit of $1.11 for a price of $57.89. Then you could hold the SDS and wait for a profit or use an options strategy to break even like selling calls or credit spreads. Another strategy could be if SDS is below $59 on expiration day, buy your puts back and take the loss which should be offset by gains in your portfolio if used as a hedge. Another consideration is to roll the short puts to a future expiration month for a net credit. That would consist of buying the puts back and then selling further out in time and maybe at a lower strike then waiting again. With any position whether it's used as a hedge or a trade, your exit strategy should be planned in advance.

click to enlarge images

P&L Graph for Synthetic Long Stock on SDSDaily Chart of SDS with the SV/IV ratio and the price moves in standard deviations

Source: Hedging Tail Risk With Synthetic Option Positions