What are Synthetic Options?

Stock exchanges are an excessively volatile arena, which means the market swings constantly. The most common way to profit from market swings is through Options. They are financial instruments that are based on the value of underlying assets such as stock. In an Options contract, the buyer has the opportunity to buy or sell depending on the type of contract they hold – the underlying asset.

With Call options, the holder can buy the asset at a declared price within a specific period. Put options, on the other hand, allow the holder to sell the asset at a declared price within a specific period. There exists a relationship between – calls, puts, and the underlying stock. It is this relationship because of which, some options positions are synthetic as compared to others also called synthetic options.

The put-call parity equation establishes a relationship between the price of a call and a put option that has the same underlying asset. Let’s dig deeper into what synthetic options are.

What are Synthetic Options?

Synthetic Options are portfolios or trading positions holding several securities that, when taken together, emulate or match the position of another asset. The payoff of the ‘synthetic’ position and the actual position should ideally be the same. If the prices for these two positions are not identical, then an arbitrage opportunity would arise in the market.

Many snags can be reduced or even eliminated when a trader utilizes a synthetic option in place of purchasing a plain option. The impact of an option expiring is much lesser when it comes to synthetic options. Adverse statistics can work in their favor. This is because volatility, decay, and strike price plays a less important role in its eventual outcome. In practice, traders often create synthetic positions to adjust existing positions.

Synthetic options undoubtedly have worthier qualities in comparison to regular options. However, some disadvantages come along with synthetic options as well. Assuming the market moves against a cash or futures position, this essentially means that it is losing money in real-time. With a protective option in place, it is intended to rise in value at the same pace. This way one can cover their losses.

This is best achieved with an at-the-money option. However, these are more expensive than when compared to an out-of-the-money option. Consequently, this can have significant repercussions on the amount of capital that is committed to the trade. Even with the protection of an at-the-money option, the trader must have a solid money management strategy to figure out when to get out of the cash or futures position. If traders do not chart out a plan to limit losses, they can miss opportunities to switch a losing synthetic position to a profitable one.

Types of synthetic options

There are two types of synthetic options: synthetic call options and synthetic put options. Both of these require a cash or futures position in combination with an option. The cash or futures position makes the primary position whereas the option makes the shielding or 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.

Synthetic long call

A synthetic call option, also called a synthetic long call, begins when an investor buys and holds shares. At the same time, the investor buys an at-the-money put option on the same stock to protect themselves from any depreciation in the stock price. This strategy may be considered similar to taking an insurance policy against any severe price drops in stock, during the duration of holding. A synthetic call is also known as a married call or protective call.

Synthetic long put

A synthetic put is a synthetic options strategy that combines a short stock position with a long call option, on that same stock to imitate a long put option. It is also commonly referred to as a synthetic long put. An investor with a short position in a particular stock buys an at-the-money call option on the same stock as a protective measure against any appreciation in the stock price.

Why use synthetic options trading strategies?

Synthetic options are used for several reasons.

  • An investor can enter a synthetic position to modify an already existing position when expectations from the trade evolve. This permits a position to be modified without closing in on the existing position. For instance, if you, as an investor, are already holding a long position on a particular stock, and are concerned about the uncertainty of any downside risk, you can enter a synthetic call option position simply by buying a put option. By engineering the synthetic call, you can continue to hold the underlying stock. This can be important to investors if they have any other qualifying considerations like a need to hold ownership (stock) in a company.
  • Creating synthetic positions may also reduce the number of transactions you would need to make, to alter your position. Each transaction generally comes at a cost. Let's take the same example from the point above. If you were an investor or a trader and wished to change your position from a long stock position to a call position without using a synthetic position, you would essentially have to sell the stock and buy the call option. Here, two transactions are being processed rather than just one where you buy the put option. Reducing the quantum of transactions can be important to efficient trading.
  • Synthetic options can also be used to employ arbitrage trading strategies. If you can recognize a synthetic position that is misplaced due to the actual position, in this case, there is a potential for gain. For instance, if a call option is more expensive than the synthetic call option, you could short the former and then buy the latter. This way, you would make a profit.

Final word

You may be interested in trading futures, currencies, or in the purchase of company shares. Our advice is don’t neglect options. Options offer a reasonable way to invest with limited capital.