Synthetic Position Explained

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Understanding Synthetic Options

Options are touted as one of the most common ways to profit from market swings. Whether you are interested in trading futures, currencies or want to buy shares of a corporation, options offer a low-cost way to make an investment with less capital.

While options have the ability to limit a trader’s total investment, options also expose traders to volatility, risk, and adverse opportunity cost. Given these limitations, a synthetic option may be the best choice when making exploratory trades or establishing trading positions.

Key Takeaways

  • A synthetic option is a way to recreate the payoff and risk profile of a particular option using combinations of the underlying instrument and different options.
  • A synthetic call is created by a long position in the underlying combined with a long position in an at-the-money put option.
  • A synthetic put is created by a short position in the underlying combined wit a long position in an at-the-money call option.
  • Synthetic options are viable due to put-call parity in options pricing.

Options Overview

There is no question that options have the ability to limit investment risk. If an option costs $500, the maximum that can be lost is $500. A defining principle of an option is its ability to provide an unlimited opportunity for profit with limited risk.

However, this safety net comes with a cost because many studies indicate the vast majority of options held until expiration expire worthless. Faced with these sobering statistics, it is difficult for a trader to feel comfortable buying and holding an option for too long.

Options “Greeks” complicate this risk equation. The Greeks—delta, gamma, vega, theta, and rho—measure different levels of risk in an option. Each one of the Greeks adds a different level of complexity to the decision-making process. The Greeks are designed to assess the various levels of volatility, time decay and the underlying asset in relation to the option. The Greeks make choosing the right option a difficult task because there is the constant fear that you are paying too much or that the option will lose value before you have a chance to gain profits.

Finally, purchasing any type of option is a mixture of guesswork and forecasting. There is a talent in understanding what makes one option strike price better than another strike price. Once a strike price is chosen, it is a definitive financial commitment and the trader must assume the underlying asset will reach the strike price and exceed it to book a profit. If the wrong strike price is chosen, the entire strategy will most likely fail. This can be quite frustrating, particularly when a trader is right about the market’s direction but picks the wrong strike price.

Synthetic Options

Many problems can be minimized or eliminated when a trader uses a synthetic option instead of purchasing a vanilla option. A synthetic option is less affected by the problem of options expiring worthless; in fact, adverse statistics can work in a synthetic’s favor because volatility, decay and strike price play a less important role in its ultimate outcome.

There are two types of synthetic options: synthetic calls and synthetic puts. Both types require a cash or futures position combined with an option. The cash or futures position is the primary position and the option is the protective position. Being long in the cash or futures position and purchasing a put option is known as a synthetic call. A short cash or futures position combined with the purchase of a call option is known as a synthetic put.

A synthetic call lets a trader put on a long futures contract at a special spread margin rate. It is important to note that most clearing firms consider synthetic positions less risky than outright futures positions and therefore require a lower margin. In fact, there can be a margin discount of 50% or more, depending on volatility.

A synthetic call or put mimics the unlimited profit potential and limited loss of a regular put or call option without the restriction of having to pick a strike price. At the same time, synthetic positions are able to curb the unlimited risk that a cash or futures position has when traded without offsetting risk. Essentially, a synthetic option has the ability to give traders the best of both worlds while diminishing some of the pain.

How a Synthetic Call Works

A synthetic call, also referred to as a synthetic long call, begins with an investor buying and holding shares. The investor also purchases an at-the-money put option on the same stock to protect against depreciation in the stock’s price. Most investors think this strategy can be considered similar to an insurance policy against the stock dropping precipitously during the duration that they hold the shares.

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How a Synthetic Put Works

A synthetic put is an options strategy that combines a short stock position with a long call option on that same stock to mimic a long put option. It is also called a synthetic long put. Essentially, an investor who has a short position in a stock purchases an at-the-money call option on that same stock. This action is taken to protect against appreciation in the stock’s price. A synthetic put is also known as a married call or protective call.

Disadvantages of Synthetic Options

While synthetic options have superior qualities compared to regular options, that doesn’t mean that they don’t generate their own set of problems.

If the market begins to move against a cash or futures position it is losing money in real time. With the protective option in place, the hope is that the option will move up in value at the same speed to cover the losses. This is best accomplished with an at-the-money option but they are more expensive than an out-of-the-money option. In turn, this can have an adverse effect on the amount of capital committed to a trade.

Even with an at-the-money option protecting against losses, the trader must have a money management strategy to determine when to get out of the cash or futures position. Without a plan to limit losses, he or she can miss an opportunity to switch a losing synthetic position to a profitable one.

Also, if the market has little to no activity, the at-the-money option can begin to lose value due to time decay.

Example of a Synthetic Call

Assume the price of corn is at $5.60 and market sentiment has a long side bias. You have two choices: you can purchase the futures position and put up $1,350 in margin or buy a call for $3,000. While the outright futures contract requires less than the call option, you’ll have unlimited exposure to risk. The call option can limit risk but is $3,000 is a fair price to pay for an at-the-money option and, if the market starts to move down, how much of the premium will be lost and how quickly will it be lost?

Let’s assume a $1,000 margin discount in this example. This special margin rate allows traders to put on a long futures contract for only $300. A protective put can then be purchased for only $2,000 and the cost of the synthetic call position becomes $2,300. Compare this to the $3,000 for a call option alone, booking is an immediate $700 savings.

Put-Call Parity

The reason that synthetic options are possible is due to the concept of put-call parity implicit in options pricing models. Put-call parity is a principle that defines the relationship between the price of put options and call options of the same class, that is, with the same underlying asset, strike price, and expiration date.

Put-call parity states that simultaneously holding a short put and long European call of the same class will deliver the same return as holding one forward contract on the same underlying asset, with the same expiration, and a forward price equal to the option’s strike price. If the prices of the put and call options diverge so that this relationship does not hold, an arbitrage opportunity exists, meaning that sophisticated traders can theoretically earn a risk-free profit. Such opportunities are uncommon and short-lived in liquid markets.

The equation expressing put-call parity is:

The Bottom Line

It’s refreshing to participate in options trading without having to sift through a lot of information in order to make a decision. When done right, synthetic options have the ability to do just that: simplify decisions, make trading less expensive and help to manage positions more effectively.

Synthetic

What is Synthetic?

Synthetic is the term given to financial instruments that are engineered to simulate other instruments while altering key characteristics. Often synthetics will offer investors tailored cash flow patterns, maturities, risk profiles and so on. Synthetic products are structured to suit the needs of the investor.

NYIF Instructor Series: Synthetic Stock

Understanding Synthetic Positions

There are many different reasons behind the creation of synthetic positions. A synthetic position, for example, may be undertaken to create the same payoff as a financial instrument using other financial instruments. A trader may chose to create a synthetic short position using options as it is easier than borrowing stock and selling it short. This also applies to long positions, as traders can mimic a long position in a stock using options without having to lay out the capital to actually purchase the stock.

Key Takeaways

  • A synthetic is an investment that is meant to imitate another investment.
  • Synthetic positions can allow traders to take a position without laying out the capital to actually buy or sell the asset.
  • Synthetic products are custom designed investments that are created for large investors.

Example of a Synthetic Position

For example, you can create a synthetic option position by purchasing a call option and simultaneously selling a put option on the same stock. If both options have the same strike price, let’s say $45, this strategy would have the same result as purchasing the underlying security at $45 when the options expire or are exercised. The call option gives the buyer the right to purchase the underlying security at the strike, and the put option obligates the seller to purchase the underlying security from the put buyer.

If the market price of the underlying security increases above the strike price, the call buyer will exercise his option to purchase the security at $45, realizing the profit. On the other hand, if the price falls below the strike, the put buyer will exercise his right to sell to the put seller who is obligated to buy the underlying security at $45. So the synthetic option position would have the same fate as a true investment in the stock, but without the capital outlay. This is, of course, a bullish trade and the bearish trade is done by reversing the two options (selling a call and buying a put).

Understanding Synthetic Cash Flows and Products

Synthetic products and more complex than synthetic positions, as they tend to be custom builds created through contracts. There are two main types of generic securities investments: those that pay income and those that pay in price appreciation. Some securities straddle a line, such as a dividend paying stock that also experiences appreciation. For most investors, a convertible bond is as synthetic as things need to get.

Convertible bonds are ideal for companies that want to issue debt at a lower rate. The goal of the issuer is to drive demand for a bond without increasing the interest rate or the amount it must pay for the debt. The attractiveness of being able to switch debt for the stock if it takes off, attracts investors that want steady income but are willing to forgo a few points of that for the potential of appreciation. Different features can be added to the convertible bond to sweeten the offer. Some convertible bonds offer principal protection. Other convertible bonds offer increased income in exchange for a lower conversion factor. These features act as incentives for bondholders.

Imagine, however, that is an institutional investor that wants a convertible bond for a company that has never issued one. To fulfill this market demand, investment bankers work directly with the institutional investor to create a synthetic convertible purchasing the parts – in this case bonds and a long-term call option – to fit the specific characteristics that the institutional investor wants. Most synthetic products are composed of a bond or fixed income product, to safeguard the principal investment, and an equity component, to achieve alpha.

The Rabbit Hole of Synthetic Creations

Products used for synthetic products can be assets or derivatives, but synthetic products themselves are inherently derivatives. That is, the cash flows they produce are derived from other assets. There’s even an asset class known as synthetic derivatives. These are the securities that are reverse engineered to follow the cash flows of a single security.

Synthetic products get far more complex than synthetic convertibles or positions. Synthetic CDOs, for example, invest in credit default swaps. The synthetic CDO itself is further split into tranches that offer different risk profiles to large investors. These products can offer significant returns, but the nature of the structure can also leave high-risk, high-return tranche holders facing contractual liabilities that are not fully valued at the time of purchase. The innovation behind synthetic products has been a boon to global finance, but events like the financial crisis of 2007-09 suggest that the creators and buyers of synthetic products are not as well-informed one would hope.

Synthetic Long Stock

The synthetic long stock is an options strategy used to simulate the payoff of a long stock position. It is entered by buying at-the-money calls and selling an equal number of at-the-money puts of the same underlying stock and expiration date.

Synthetic Long Stock Construction
Buy 1 ATM Call
Sell 1 ATM Put

This is an unlimited profit, unlimited risk options trading strategy that is taken when the options trader is bullish on the underlying security but seeks a low cost alternative to purchasing the stock outright.

Unlimited Profit Potential

Similar to a long stock position, there is no maximum profit for the synthetic long stock. The options trader stands to profit as long as the underlying stock price goes up.

The formula for calculating profit is given below:

  • Maximum Profit = Unlimited
  • Profit Achieved When Price of Underlying > Strike Price of Long Call + Net Premium Paid
  • Profit = Price of Underlying – Strike Price of Long Call – Net Premium Paid

Unlimited Risk

Like the long stock position, heavy losses can occur for the synthetic long stock if the underlying stock price takes a dive.

Additionally, a debit is usually taken when entering this position since calls are generally more expensive than puts. Hence, even if the underlying stock price remains unchanged on expiration date, there will still be a loss equal to the initial debit taken.

The formula for calculating loss is given below:

  • Maximum Loss = Unlimited
  • Loss Occurs When Price of Underlying

Breakeven Point(s)

The underlier price at which break-even is achieved for the synthetic long stock position can be calculated using the following formula.

  • Breakeven Point = Strike Price of Long Call + Net Premium Paid

Example

Suppose XYZ stock is trading at $40 in June. An options trader setups a synthetic long stock by selling a JUL 40 put for $100 and buying a JUL 40 call for $150. The net debit taken to enter the trade is $50.

If XYZ stock rallies and is trading at $50 on expiration in July, the short JUL 40 put will expire worthless but the long JUL 40 call expires in the money and has an intrinsic value of $1000. Subtracting the initial debit of $50, the options trader’s profit comes to $950. Comparatively, this is very close to the profit of $1000 for a long stock position.

On expiration in July, if XYZ stock is instead trading at $30, the long JUL 40 call will expire worthless while the short JUL 40 put will expire in the money and be worth $1000. Buying back this short put will require $1000 and together with the initial $50 debit taken when entering the trade, the trader’s loss comes to $1050. This amount closely approximates the $1000 loss of the corresponding long stock position.

Commissions

For ease of understanding, the calculations depicted in the above examples did not take into account commission charges as they are relatively small amounts (typically around $10 to $20) and varies across option brokerages.

However, for active traders, commissions can eat up a sizable portion of their profits in the long run. If you trade options actively, it is wise to look for a low commissions broker. Traders who trade large number of contracts in each trade should check out OptionsHouse.com as they offer a low fee of only $0.15 per contract (+$4.95 per trade).

Synthetic Long Stock (Split Strikes)

There is a less aggressive version of this strategy where both the call and put options involved are out-of-the-money. While a larger upside movement of the underlying stock price is required to accrue large profits, this alternative strategy does provide more room for error.

Synthetic Short Stock

The companion strategy to the synthetic long stock is the synthetic short stock. Unlike the synthetic long stock which merely simulates the long stock position, the synthetic short stock is deemed to be superior to the actual short sale of the underlying for a number of important reasons.

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