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Synthetic Options

Updated on April 4, 2024
Article byShrestha Ghosal
Edited byShrestha Ghosal
Reviewed byDheeraj Vaidya, CFA, FRM

What Are Synthetic Options?

Synthetic options are a trading strategy where investors merge several trading positions to replicate the position of another asset or financial instrument. Traders usually create these options positions with the aim of adjusting their existing positions. These options are versatile, allowing investors to switch positions whenever they want.

Synthetic Options

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The payouts from synthetic options positions are the same as that of an actual position. However, specific market conditions like expiration date, strike price, and market volatility impact the returns investors earn from these options positions less. These options help investors experience trading an asset without exposure to the risks of holding an actual position.

Key Takeaways

  • Synthetic options are a trading strategy in which investors combine multiple positions to imitate another asset or financial instrument’s position.
  • This options strategy allows the traders to experience trading an asset or financial instrument’s position without having to own or hold that position. 
  • It safeguards the traders from the adverse effects of market conditions like strike price, expiration period, and market volatility.
  • It enables investors to swap positions quickly. It also allows investors to create an arbitrage strategy.

Synthetic Options Explained

Synthetic options are trading strategies in which traders combine various positions like short, long, put, or call to mirror another asset’s position. These options help investors in adjusting their existing positions. Additionally, these options are quite flexible, allowing traders to switch positions quickly without closing previous positions. Furthermore, investors may not require to change the entire position to make slight alterations.

Synthetic options trading may allow the investor to create an arbitrage strategy. Additionally, these options can help the traders earn a profit on their returns while minimizing the potential risks. These options can also limit the number of transactions investors require to alter their positions. As a result, it allows efficient trading since each transaction usually comes at a cost.

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Types

The synthetic options types are as follows:

#1 – Synthetic Long Put

A synthetic long put is also known as a synthetic put option. In this strategy, the traders merge a long call option with a short stock position on the same asset to mirror a long put option. For example, investors with a short position in a security purchase can purchase an investment with an at-the-money call option on the same security to use as protection against any appreciation in the asset price.

#2 – Synthetic Long Call

A synthetic long call is also known as a synthetic call option. This process starts when an investor purchases and holds some assets or securities. Additionally, the investor buys an at-the-money put option on the same securities to prevent the risk of losing money against depreciation in the asset’s price. This options strategy protects the traders from the negative impacts of a price fall. This call is also known as a protective call or a married call.

How To Use?

Synthetic options trading comes with the following two options: 

  • Synthetic calls 
  • Synthetic puts

These option types have a cash or futures position along with an option. The cash or futures position is considered the leading position, while the option is the shielding position.

For example, a synthetic call occurs when the traders choose to be long in the cash or futures position and buy a put option. In contrast, a synthetic put happens when the traders combine a short cash or futures position with purchasing a call option.

A synthetic put or call option replicates the limited loss and unlimited profit potential of the regular put or call option. However, it does not require the investor to select a strike price. Furthermore, these options positions allow the traders to manage the unlimited risk of trading a cash or futures position without neutralizing the threat.

Examples of Synthetic Options

Let us understand this concept with the following examples:

Example #1

Suppose David purchased the shares of a company named Apex Ltd. The current market price of Apex Ltd.’s stocks is $2400. Mr. David is anticipating a bullish trend, but at the same time, he is concerned about incurring losses if the share prices start to decline. So, he purchased a put option with a strike price of $2300 with a $150 premium. If the stock prices increase, David will make unlimited profits as his stock price rises. However, he will lose the premium paid to buy the put option. This is an example of synthetic options.

Example #2

Suppose Green purchased the stocks of ThoughtWorks Company. The current market price of its stocks is $3400. Green is expecting a bullish market. However, she wants to safeguard herself from losses if the stock prices fall. So, she purchased a put option with a strike price of $3300 with a $250 premium. If the share prices start declining, the loss will be covered by the put option, as the loss incurred in the shares, she holds will be compensated by the profits she would earn from the put options.

Advantages And Disadvantages

The synthetic options strategy advantages are as follows:

  • This options strategy can shield against threats from future positions or cash. 
  • Synthetic long-put options are most suitable for declining market conditions because they can restrain potential losses. 
  • This option replicates the unlimited profit potential and the regular option’s loss potential without the limitations of a specific strike price. 
  • These options ensure that investors can profit from future options and positions while minimizing the possibility of losses.

The synthetic options’ disadvantages are as follows:

  • Traders might lose money in real-time from this options strategy if the market moves against a future position. They can increase their earnings through these options by buying an at-the-money option. However, these options are more costly than other options.
  • Investors must have a robust strategy to exit a future position while trading with these options. Otherwise, they might lose the possibility to move from a plummeting synthetic position to a more profitable one.  

Frequently Asked Questions (FAQs)

Can synthetic options be used to manage risk in a portfolio?

Yes, traders can use synthetic options to control risk in the portfolio. For example, investors can experience holding various securities or markets without taking the risk of owning those assets. In addition, this option can help an investor hedge against potential losses in the future.

How do you calculate the payoff of a synthetic option strategy?

Traders can determine the payoff from synthetic options strategy by applying the same calculations for traditional options. For example, the trader must deduct the asset’s strike price from its current market price and add the premium for the call option to calculate the payoff from a synthetic long call option. The final amount is the profit or loss from this option at the expiration period.

Are synthetic options more or less liquid than traditional options?

Usually, these options are less liquid than traditional options as investors do not trade them in large volumes or as frequently. However, the synthetic options’ liquidity depends on the underlying asset’s liquidity. As a result, the liquidity can differ according to the strategies and market conditions.

What are the main differences between synthetic options and traditional options?

The synthetic options positions mirror the payout profile of a traditional option using other financial instruments. However, the traditional options payout profile depends on the expiration date, strike price, and asset market price.

This has been a guide to what are Synthetic Options. Here, we explain the topic including their types, examples, how to use them, advantages & disadvantages. You can learn more about it from the following articles –

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