5.1. Hedging with Synthetic Calls and Puts

A trader with a speculative position in stocks or futures can hedge that position with options in exactly the same way as a holder or buyer of inventory. Besides the fact that the speculator has not entered his long position through productive labor, there is little to distinguish between the two activities. Except in name. Financial instruments that are created artificially by simulating other financial instruments are known as synthetics.

To illustrate what this means, look at the following diagram. A long futures contract is hedged with a long at-the-money put—a protective put. The straight line in the diagram represents the long futures position, which the trader has purchased at $40. If the market price rises, his profit will increase by the amount of the ris