Options can be synthetically manufactured by shifting between stocks and cash as prices move.

Evidence

What Leland had seen, however, was that although suitable actual puts were not available, a pension fund or other investor that desired portfolio insurance could use option theory to “manufacture” a synthetic put. Qualitatively, what was needed was to shift between stocks and cash (or government bonds) as stock prices fluctuated, buying stocks as prices rose and selling them as prices fell. If the value of the stock portfolio fell toward its floor, more and more of it would be sold, so the overall impact on the portfolio of further declines in stock prices became less because fewer stocks and perhaps eventually no stocks were held. Option theory could provide quantitative guidance as to how to do that in such a way that the desired put would be replicated precisely. — Donald MacKenzie, An Engine, Not a Camera, 793

Categorization

• DEFINE: Defines the core portfolio insurance mechanism: dynamic hedging that replicates a put without holding one.
• XREF: Connects to Black-Scholes hedging logic and to later 1987 crash literature on portfolio insurance’s systemic effect. — connects to: Option price must equal the cost of a continuously adjusted replicating portfolio. — Donald MacKenzie & Yuval Millo, Constructing a Market, Performing Theory, 95; Modern options pricing derives from arbitrage logic, not directional beliefs. — Donald MacKenzie, An Engine, Not a Camera: How Financial…, 1454; The CBOE automated away the missing stock price by calculating a synthetic underlying. — Donald MacKenzie & Yuval Millo, Constructing a Market, Performing Theory, 130

Broader Connections

• Modern options pricing derives from arbitrage logic, not directional beliefs. #expands (0.85) — Donald MacKenzie, An Engine, Not a Camera, 1454