Option Basics: Equivalent Positions (4:18)

By Lawrence G. McMillan

This article was originally published in The Option Strategist Newsletter Volume 4, No. 18 on September 28, 1995.

The concept of equivalent option positions is an important one, for it is often possible to substitute one strategy for another. In so doing, one might be able to accomplish additional goals while still preserving the same profit potential. These considerations might include decreased commissions, tighter markets, or better use of capital.

Two positions are considered to be equivalent when their profit graphs have the same shape. As a simple example, let's look at the purchase of a call option as compared to another position: the combined purchase of a stock and the purchase of a put.

Obviously, the investments required for the two strategies in the example are not the same — only the profit potential is. In fact, after commissions are included, their profits wouldn't be exactly the same, but their profits graph would still have the same shape: limited losses on the downside and unlimited profit potential to the upside.

Even this simple equivalence can be of importance to stock holders. When worried about the downside, some stock owners sell their stock and replace it with long calls. However, given the equivalence of the above example, the same thing could be accomplished — at far less commission cost — merely by buying a put.

Another important equivalence is one that we have mentioned many times in the past: a covered call write is equivalent to the sale of a naked put. This is "old hat" to experienced option traders, but many people not familiar with options don't realize that the covered write — considered even by the courts to be a conservative strategy — and the sale of a naked put option — generally considered to be a high risk strategy — are equivalent. Yet in fact they are.

Moreover, it may be much more efficient to sell naked puts than to establish covered writes. Since one is only required to advance collateral equal to 20% of the strike price, plus the premium, in order to write a naked option, one could do covered writes with far less capital than is required for actually buying the stock and selling a call. Moreover, that collateral can be in the form of Treasury Bills, which can then earn interest while they are being used as collateral.

The most important equivalences any option trader should know — and that includes futures option traders as well — are those between the options and the underlying security:

These two equivalences have many applications. For stock traders, the option positions allow one to control the same amount of profit potential with less of an investment (20% of the stock price instead of 50% for a margin purchase or 100% on cash). Moreover, you can have the equivalent of a short position in the stock without needing an uptick to establish your position.

For futures traders, these equivalences are more than a convenience, they are a must. If you are trading futures without understanding the above equivalence, then stop trading futures until you do. For this concept will allow you to take your loss even after futures have moved the limit against you — a tactic which will allow you to preserve your capital and return to trade another day. Futures traders who don't understand this equivalence can be locked into a series of limit moves against them; something which could wipe out their entire account, because the losing futures position cannot be closed out when the futures are locked limit against you.

With the options however, it is an easy matter to extract yourself. You will take a loss, but it will be a limited one. As an example, suppose that you are long soybean futures, and they have traded down the daily limit and are locked limit down so that you cannot sell. All you need to do is buy a put and sell a call (with the same strike price and expira-tion date), and your worries are over. You have equivalently sold your futures; there is no more risk to the position.

The actual position will have to carried until expiration, when you would exercise your put or be assigned on your call — depending on which one is in-the-money — thereby actually selling your futures and closing out the position.

If you had instead been short futures and they were locked up the limit against you, it would again be a simple matter to equivalently cover them: buy a call and sell a put.

Equivalences are an important concept for option traders, and a mandatory one for futures traders. Whenever you need to accomplish a specific task that seems difficult or impossible in the stock or option market, try to see if there is an equivalent option strategy that can help you out.

This article was originally published in The Option Strategist Newsletter Volume 4, No. 18 on September 28, 1995.