Synthetic Long Futures Explained – Futures Options

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Contents

Synthetic Long Futures

The synthetic long futures is an options strategy used to simulate the payoff of a long futures position. It is entered by buying at-the-money call options and selling an equal number of at-the-money put options of the same underlying futures and expiration month.

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

This is an unlimited profit, unlimited risk options position that can be created to hedge a short futures position, often as a means to profit from an arbitrage opportunity.

The synthetic long futures strategy is also used when the futures trader is bullish on the underlying futures but seeks an alternative to purchasing the futures outright.

Unlimited Profit Potential

Similar to a long futures position, there is no maximum profit for the synthetic long futures. The futures options trader stands to profit as long as the underlying futures 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 futures position, heavy losses can occur for the synthetic long futures if the underlying futures price falls dramatically.

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 futures position can be calculated using the following formula.

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

Example

Suppose June Crude Oil futures is trading at $40 and each futures contract covers 1000 barrels of Crude Oil. A futures options trader enters a synthetic long futures position by selling a JUN Crude Oil 40 put for $5100 and buying a JUN Crude Oil 40 call for $4800. The net credit received upon entering the trade is $300.

Scenario #1: June Crude Oil futures rises to $50

If June Crude Oil futures rallies and is trading at $50 on option expiration date, the short JUN 40 put will expire worthless but the long JUN 40 call expires in the money and has an intrinsic value of $10000. Including the initial credit of $300, the trader’s profit comes to $10300. Comparatively, this is very close to the profit of $10000 for a long futures position.

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Scenario #2: June Crude Oil futures drops to $30

If June Crude Oil futures is instead trading at $30 on option expiration date, then the long JUN 40 call will expire worthless while the short JUN 40 put will expire in the money and be worth $10000. Buying back this short put will require $10000 and subtracting the initial $300 credit taken when entering the trade, the trader’s loss comes to $9700. This amount closely approximates the $10000 loss of the corresponding long futures position.

Upfront Investment

Some novice futures traders mistakenly believe that the synthetic long futures strategy requires very little upfront investment. They assumed that by trading options instead of futures, they can avoid posting the margin. Unfortunately, the short put position is subjected to the same margin requirements as a short futures position. Hence, the synthetic long futures position requires more or less the same upfront investment as a regular long futures position.

Synthetic Long Futures (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 futures price is required to accrue large profits, this alternative strategy does provide more room for error.

Synthetic Short Futures

The companion strategy to the synthetic long futures is the synthetic short futures.

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Synthetic Long Futures (Split Strikes)

The synthetic long futures (split strikes) is a less aggressive version of the synthetic long futures strategy.

The synthetic long futures (split strikes) position is created by buying slightly out-of-the-money calls and selling an equal number of slightly out-of-the-money puts of the same underlying futures and expiration month.

Synthetic Long Futures (Split Strikes) Construction
Buy 1 OTM Call
Sell 1 OTM Put

The split strike version of the synthetic long futures strategy offers some downside protection. If the trader’s outlook is wrong and the underlying futures price falls slightly, he will not suffer any loss. On the flip side, a stronger upside move is needed to produce a profit.

Profits and losses with a split strike strategy are also not as heavy as a corresponding long futures position as the strategist has traded some potential profits for downside protection.

Unlimited Profit Potential

Similar to a long futures position, there is no maximum profit for the synthetic long futures (split strikes) strategy. The options trader stands to profit as long as the underlying futures 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 Received
  • Profit = Price of Underlying – Strike Price of Long Call + Net Premium Received

Unlimited Risk

Like the long futures position, heavy losses can occur for the synthetic long futures (split strikes) if the underlying futures price falls sharply.

Often, a credit is received when establishing this position. Hence, even if the underlying futures price remains unchanged on expiration date, there will still be a profit equal to the initial credit received.

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 futures (split strikes) position can be calculated using the following formula.

  • Breakeven Point = Strike Price of Short Put – Net Premium Received OR Strike Price of Long Call + Net Premium Paid

Example

Suppose June Crude Oil futures is trading at $40 and each contract covers 1000 barrels. A trader creates a split-strikes synthetic long futures position by selling a JUN 35 put for $2200 and buying a JUN 45 call for $2000. The net credit taken to enter the trade is $200.

Scenario #1: June Crude Oil futures rise moderately to $45

If June Crude Oil futures rallies to $45 on option expiration date, both the short JUN 35 put and the long JUN 45 call will expire worthless and the trader gets to keep the initial credit of $200 as profit.

Scenario #2: June Crude Oil futures rallies explosively to $60

If June Crude Oil futures skyrockets to $60 on option expiration date, the short JUN 35 put will expire worthless but the long JUN 45 call will expire in the money and has an intrinsic value of $15000. Including the initial credit of $200, the options trader’s profit comes to $15200. Comparatively, a corresponding long futures position would have achieved a higher profit of $20000.

Scenario #3: June Crude Oil futures crashes to $20

If the price of June Crude Oil futures has instead nosedived to $20, the long JUN 45 call will expire worthless while the short JUN 35 put will expire in the money and be worth $15000. Buying back this short put will require $15000 and subtracting the initial $200 credit received when entering the trade, the trader’s loss comes to $14800. A heavier loss of $20000 loss would have been suffered by a corresponding long futures position.

Synthetic Long Futures

There is a more aggressive version of this strategy where both the call and put options involved are at-the-money. While a smaller upside movement of the underlying futures price is required to accrue large profits, this alternative strategy provides less margin for error.

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Buying straddles is a great way to play earnings. Many a times, stock price gap up or down following the quarterly earnings report but often, the direction of the movement can be unpredictable. For instance, a sell off can occur even though the earnings report is good if investors had expected great results. [Read on. ]

Writing Puts to Purchase Stocks

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Investing in Growth Stocks using LEAPS® options

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Cash dividends issued by stocks have big impact on their option prices. This is because the underlying stock price is expected to drop by the dividend amount on the ex-dividend date. [Read on. ]

Bull Call Spread: An Alternative to the Covered Call

As an alternative to writing covered calls, one can enter a bull call spread for a similar profit potential but with significantly less capital requirement. In place of holding the underlying stock in the covered call strategy, the alternative. [Read on. ]

Dividend Capture using Covered Calls

Some stocks pay generous dividends every quarter. You qualify for the dividend if you are holding on the shares before the ex-dividend date. [Read on. ]

Leverage using Calls, Not Margin Calls

To achieve higher returns in the stock market, besides doing more homework on the companies you wish to buy, it is often necessary to take on higher risk. A most common way to do that is to buy stocks on margin. [Read on. ]

Day Trading using Options

Day trading options can be a successful, profitable strategy but there are a couple of things you need to know before you use start using options for day trading. [Read on. ]

What is the Put Call Ratio and How to Use It

Learn about the put call ratio, the way it is derived and how it can be used as a contrarian indicator. [Read on. ]

Understanding Put-Call Parity

Put-call parity is an important principle in options pricing first identified by Hans Stoll in his paper, The Relation Between Put and Call Prices, in 1969. It states that the premium of a call option implies a certain fair price for the corresponding put option having the same strike price and expiration date, and vice versa. [Read on. ]

Understanding the Greeks

In options trading, you may notice the use of certain greek alphabets like delta or gamma when describing risks associated with various positions. They are known as “the greeks”. [Read on. ]

Valuing Common Stock using Discounted Cash Flow Analysis

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Synthetic Futures Contract

What is a Synthetic Futures Contract?

A synthetic futures contract uses put and call options with the same strike price and expiration date to simulate a traditional futures contract.

Key Takeaways

  • A synthetic futures contract uses put and call options with the same strike price and expiration date to simulate a traditional futures contract.
  • Synthetic futures contracts can help investors reduce their risk.
  • A major advantage of a synthetic futures contract is that a “future” position can be maintained without the same types of requirements for counterparties, including the risk that one of the parties will renege on the agreement.

Understanding Synthetic Futures Contracts

The purpose of a synthetic futures contract, also called a synthetic forward contract, is to mimic a regular futures contract. The investor will typically pay a net option premium when executing a synthetic futures contract as the premium paid is, usually, not offset by the premium collected.

There are two types of traditional futures contracts that can be replicated by synthetic futures contracts:

  1. Long futures position: Buy calls and sell puts with the identical strike price and expiration date.
  2. Short futures position: Buy puts and sell calls with the identical strike price and expiration date.

Synthetic futures contracts can help investors reduce their risk, although as with trading futures outright, investors still face the possibility of significant losses if they don’t implement proper risk management strategies. Another major advantage of a synthetic futures contract is that a “future” position can be maintained without the same types of requirements for counterparties, including the risk that one of the parties will renege on the agreement.

Synthetic Long Futures Contract

To create a synthetic long futures contract on a stock, buy a call with a $60 strike price and, at the same time, sell a put with a $60 strike price and same expiration date. At expiration, the investor will buy the underlying asset by paying the strike price, no matter which way the market moves before that time.

  • If the stock price is above the strike price on the expiration date, the investor, who owns the call, will want to exercise that option and pay the strike price to buy the stock.
  • If the stock price at expiration is below the strike price, the owner of the put that was sold will want to exercise that option. The result is the investor will also buy the stock by paying the strike price.
  • In either case, the investor ends up buying the stock at the strike price, which was locked in when the synthetic futures contract was established.

Keep in mind that there could be a cost for this guarantee. It all depends on the strike price and expiration date chosen. Put and call options with the same strike and expiration may be priced differently, depending on how far in or out of the money the strike prices may be. Typically, the parameters chosen end up with the call premium being slightly higher than the put premium, creating a net debit in the account at the start.

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