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Master Class: Options and Derivatives Crash Course: Session Five: Synthetics

Building blocks and synthetic configurations

The basic building blocks in the derivative world are the three contract types that we have just discussed. It is possible to combine any number of them in a configuration that has a desired payoff profile.

ProductPositionDirection
CallLongBullish
CallShortBearish
PutLongBearish
PutShortBullish
ForwardLongBullish
ForwardShortBearish

A user can combine any two of the above three products to synthetically create the third. For example we can combine calls and puts to synthetically create both long and short forward contracts.

Product AProduct B = Product Three
Long CallShort PutLong Forward
Long PutShort CallShort Forward

The concept in the above table is illustrated in the following three diagrams.

Comparing a Call with a Forward contract

Payoff Profile Calls And Puts 5

Comparing a Call and a Put with a Forward contract

Payoff Profile Calls And Puts 6

Combining a long call with a short put to create a long forward

Payoff Profile Calls And Puts 7

Addendum: What is wrong with the payoff profile of the synthetic forward?

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