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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.
- 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.
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.
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.
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.
There is a synthetic equivalent for all of the basic positions in an underlying security and its corresponding options. In other words, the risk/reward profile of any position can be simulated using a complex combination of the other basic positions. These equivalents are known as synthetic underlying and synthetic options respectively for the underlying security (e.g. stock or futures) and options positions.
Synthetic positions are often used to perform arbitrage trades in options trading. When prices are right, the arbitrager can make a risk-free profit by going long/short on one position while simultaneously selling/buying the equivalent synthetic position.
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Understanding Synthetic Positions
The basic definition of synthetic positions is that they are trading positions created to emulate the characteristics of another position. More specifically, they are created in order to recreate the same risk and reward profile as an equivalent position. In options trading, they are created primarily in two ways.
You can use a combination of different options contracts to emulate a long position or a short position on stock, or you can use a combination of option contracts and stocks to emulate a basic options trading strategy. In total, there are six main synthetic positions that can be created, and traders use these for a variety of reasons.
The concept may sound a little confusing and you may even be wondering why you would need or want to go through the trouble of creating a position that is basically the same as another one. The reality is that synthetic positions are by no means essential in options trading, and there’s no reason why you have to use them.
However, there are certain benefits to be gained, and you may find them useful at some point. On this page, we explain some of the reasons why traders do use those positions, and we also provide details on the six main types.
- Why use Synthetic Positions?
- Synthetic Long Stock
- Synthetic Short Stock
- Synthetic Long Call
- Synthetic Short Call
- Synthetic Long Put
- Synthetic Short Put
Why Use Synthetic Positions?
There are a number of reasons why options traders use synthetic positions, and these primarily revolve around the flexibility that they offer and the cost saving implications of using them. Although some of the reasons are unique to specific types, there are essentially three main advantages and these advantages are closely linked. First, is the fact that synthetic positions can easily be used to change one position into another when your expectations change without the need to close out the existing ones.
For example, letвЂ™s imagine you have written calls in the expectation that the underlying stock would drop in price over the coming weeks, but then an unexpected change in market conditions leads you to believe that the stock would actually increase in price. If you wanted to benefit from that increase in the same way you were planning to benefit from the fall, then you would need to close your short position, possibly at a loss, and then write puts.
However, you could recreate the short put options position by simply buying a proportionate amount of the underlying stock. You have actually created a synthetic short put as being short on calls and long on the actual stock is effectively the same as being short on puts. The advantage of the synthetic position here is that you only had to place one order to buy the underlying stock rather than two orders to close your short call position and secondly to open your short put position.
The second advantage, very similar to the first, is that when you already hold a synthetic position, it’s then potentially much easier to benefit from a shift in your expectations. We will again use an example of a synthetic short put.
You would use a traditional short put (i.e. you would write puts) if you were expecting a stock to rise only a small amount in value. The most you stand to gain is the amount you have received for writing the contracts, soit doesnвЂ™t matter how much the stock goes up; as long it goes up enough that the contracts you wrote expire worthless.
Now, if you were holding a short put position and expecting a small rise in the underlying stock, but your outlook changed and you now believed that the stock was going to rise quite significantly, you would have to enter a whole new position to maximize any profits from the significant rise.
This would typically involve buying back the puts you wrote (you may not have to do this first, but if the margin required when you wrote them tied up a lot of your capital you might need to) and then either buying calls on the underlying stock or buying the stock itself. However, if you were holding a synthetic short put position in the first place (i.e. you were short on calls and long on the stock), then you can simply close the short call position and then just hold on to the stock to benefit from the expected significant rise.
The third main advantage is basically as a result of the two advantages already mentioned above. As you will note, the flexibility of synthetic positions usually means that you have to make less transactions. Transforming an existing position into a synthetic one because your expectations have changed typically involves fewer transactions than exiting that existing position and then entering another.
Equally, if you hold a synthetic position and want to try and benefit from a change in market conditions, you would generally be able to adjust it without making a complete change to the positions you hold. Becaus of this, synthetic positions can help you save money. Fewer transactions means less in the way of commissions and less money lost to the bid ask spread.
Synthetic Long Stock
A synthetic long stock position is where you emulate the potential outcomes of actually owning stock using options. To create one, you would buy at the money calls based on the relevant stock and then write at the money puts based on the same stock.
The price that you pay for the calls would be recouped by the money you receive for writing puts, meaning that if the stock failed to move in price you would neither lose nor gain: the same as owning stock. If the stock increased in price, then you would profit from your calls, but if it decreased in price, then you would lose from the puts you wrote. The potential profits and the potential losses are essentially the same as with actually owning the stock.
The biggest benefit here is the leverage involved; the initial capital requirements for creating the synthetic position are less than for buying the corresponding stock.
Synthetic Short Stock
The synthetic short stock position is the equivalent of short selling stock, but using only options instead. Creating the position requires the writing of at the money calls on the relevant stock and then buying at the money puts on the same stock.
Again, the net outcome here is neutral if the stock doesn’t move in price. The capital outlay for buying the puts is recouped through writing the calls. If the stock fell in price, then you would gain through the purchased puts, but if it increased in price, then you would lose from the written calls. The potential profits and the potential losses are roughly equal to what they would be if you were short selling the stock.
There are two main advantages here. The primary advantage is again leverage, while the second advantage is related to dividends. If you have short sold stock and that stock returns a dividend to shareholders, then you are liable to pay that dividend. With a synthetic short stock position you don’t have the same obligation.
Synthetic Long Call
A synthetic long call is created by buying put options and buying the relevant underlying stock. This combination of owning stocks and put options based on that stock is effectively the equivalent of owning call options. A synthetic long call would typically be used if you owned put options and were expecting the underlying stock to fall in price, but your expectations changed and you felt the stock would increase in price instead. Rather than selling your put options and then buying call options, you would simply recreate the payoff characteristics by buying the underlying stock and creating the synthetic long call position. This would mean lower transaction costs.
Synthetic Short Call
A synthetic short call involves writing puts and short selling the relevant underlying stock. The combination of these two positions effectively recreates the characteristics of a short call options position. It would usually be used if you were short on puts when expecting the underlying stock to rise in price and then had reason to believe the stock would actually fall in price.
Instead of closing your short put options position and then shorting calls, you could recreate being short on calls by short selling the underlying stock. Again, this means lower transaction costs.
Synthetic Long Put
A synthetic long put is also typically used when you were expecting the underlying security to rise, and then your expectations change and you anticipate a fall. If you had bought call options on stock that you were expecting to rise, you could simply short sell that stock. The combination of being long on calls and short on stocks is roughly the same as holding puts on the stock вЂ“ i.e. being long on puts.
When you already own calls, creating a long put position would involve selling those calls and buying puts. By holding on to the calls and shorting the stock instead, you are making fewer transactions and therefore saving costs.
Synthetic Short Put
A normal short put position is usually used when you are expecting the price of an underlying stock increase by moderate amount. The synthetic short put position would generally be used when you had previously been expecting the opposite to happen (i.e. a moderate drop in price).
If you were holding a short call position and wanted to switch to a short put position, you would have to close your existing position and then write new puts. However, you could create a synthetic short put instead and simply buy the underlying stock. A combination of owning stock and having a short call position on that stock essentially has the same potential for profit and loss as being short on puts.
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