Synthetic Position

Updated on April 4, 2024
Article byRutan Bhattacharyya
Edited byRutan Bhattacharyya
Reviewed byDheeraj Vaidya, CFA, FRM

What Is A Synthetic Position?

Synthetic positions are trading options allowing traders to recreate a specific financial instrument’s risk profile and payoff utilizing various other financial instruments. It enables individuals engaging in securities trading to enter a position without utilizing any capital actually to purchase or offload the asset.

Synthetic Position

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Traders prefer such positions as they are cost-friendly and flexible. This is a common way for individuals to make profits from market swings. Also, one can use them to swap positions if a change in expectation happens without demanding the existing ones’ closure. There are various types of synthetic positions. For example, synthetic long call and synthetic short and stock.

Key Takeaways

  • Synthetic position refers to a way in which traders can simulate two specific characteristics — the payoff and risk profile of another position that is comparable.
  •  There are multiple reasons for using this trading option. For example, one can develop a synthetic position to alter their position easily without closing their existing positions if a change in expectations occurs.
  • A key disadvantage of this trading option is that one requires a sound strategy for exiting a cash or futures position.
  • Such a position safeguards traders against the unlimited risk of cash or futures positions.

Synthetic Position Explained

Synthetic position refers to a trading position created to simulate the characteristics of another comparable position. Individuals can take a position without requiring capital to buy or sell the asset using this trading option.

In options trading, one can develop synthetic positions in two ways. They can create it through a combination of different options or contracts to match a long or short position on the security. The second approach involves utilizing a sequence of options contracts or stocks to emulate a standard approach of options trading.

The majority of the clearing firms consider outright futures positions riskier than such positions. Hence, a synthetic position in trading requires a lower margin. Indeed, depending on volatility, a margin discount of more than 50% might be available.

Synthetic calls or puts mimic a regular call or put option’s restricted loss and unlimited profit potential without choosing a strike price. That said, one must note that synthetic positions can simultaneously restrict a futures or cash position‘s unlimited risk when one trades without offsetting risk.

Thus, besides providing traders with the best of both worlds, synthetic option positions can reduce a part of the uncertainty. Thus, such positions can offer the best of both worlds to traders.

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Types

The different types of synthetic positions are as follows:

#1 – Synthetic Short Stock

It is the same as short selling an existing stock. That said, the position utilizes options only. Creating this kind of position involves writing on the relevant stocks’ ATM calls. Later, the stock is purchased through ATM or at-the-money puts. One considers the outcome natural if the stock’s price does not rise.

It offers two noteworthy benefits — there is much to be leveraged, and the stock offers significant dividends.

#2 – Synthetic Short Call

Creating this position involves taking a short position on the put option and short selling. Such positions recreate the characteristics of a short call option.

Individuals often use such a position if a shortage of put exists and they expect the stock’s price to rise. That said, in reality, an individual interested in the stock expects the price to fall.

#3 – Synthetic Long Call

The creation of such a position occurs when stocks are bought via a put option. This allows the purchase of relevant stocks. Typically, persons use it when they own put options, and the stock’s price is expected to drop, but the expectations changed owing to the hope that the prices would rise.

#4 – Synthetic Long Stock

It involves simulating the potential results of actually owning stock through the use of trade options. To develop this position, one must purchase stocks via ATM calls before recording ATM puts off an equivalent stock. In this case, the accruing leverage is the source of benefit.

Examples

Let us look at a few synthetic position examples to understand the concept better.

Example #1

Suppose David, a trader, had written calls expecting the underlying stock price would decrease over the coming weeks. However, unforeseen changes in market conditions led him to believe that the stock’s price would actually rise. If he wanted to benefit from the surge in price in the same way he planned on benefiting from the decrease, he had to close the short position, probably at a loss, before writing puts.

That said, he purchased a proportionate amount of the underlying security to emulate the short put options position. By doing this, he developed a synthetic short put as being long on the actual shares and short on the calls is virtually equivalent to being short on puts.

Here, the synthetic position’s benefit is that David had to place a single order to purchase the underlying stock instead of two to lose his short call position and open a short call position.

Example #2

Suppose Sam would utilize conventional short put as he expected a stock’s price to increase by only a small amount. In this case, the money he could earn was the sum received for writing contracts. Hence, it did not matter how much the security’s price surged as long as it increased enough, so the contracts he wrote expired worthless.

That said, suppose he held a short position and anticipated a small increase in the underlying security’s price. Then, however, the outlook altered, and he started believing that the stock price would rise significantly. In that case, he had to enter a completely new position to maximize the profits from the significant price rise.

Typically, this would have involved buying back the puts he wrote and then purchasing the calls on the underlying security or purchasing the financial instrument itself. That said, if he held a synthetic position, to begin with, then Same could simply close his short position and hold the security to take advantage of the expected price increase.

Reasons For Using

Let us look at the reasons for using such positions.

  1. Traders can use such positions easily to change a position into another when their expectations alter without the requirement of closing out positions that already exist.  
  2. When traders already hold such a position, it becomes potentially easier for them to take advantage of a shift in their expectations.
  3. The third benefit is a result of the above two uses. The flexibility of such positions indicates that one does not need to carry out transactions frequently. This way, the transformation of an existing position into a synthetic form can take place as the expectations may change at any time.
  4. If traders already hold such a position and want to benefit from an alteration in market condition, they could typically make adjustments to it without needing to make a complete change.  

Advantages And Disadvantages

Let us look at the benefits and limitations of synthetic position in trading.

#1 – Advantages

  • Such trading options serve as a cushion against the unlimited risk associated with futures or cash positions. In bearish conditions, a synthetic long put is ideal because it restricts potential losses.
  • Such a position enables traders to generate earnings from options and futures positions while reducing the chances of risks.
  • This trading option mimics the loss potential and unlimited profit potential of futures or cash positions without restrictions concerning a specific strike price.

#2 – Disadvantages

  • Traders need a well-thought-out strategy to exit a futures or cash position. Without it, they might miss a chance to shift from a sinking synthetic position to a profitable one.
  • If the market starts moving against a cash or futures position, it probably will lose money for the traders in real-time. Individuals can make the value move up using options by buying an ATM option. That said, one must note that ATM options are more expensive than the OTM (Out-Of-The-Money) ones.  

Frequently Asked Questions (FAQs)

1. How to create a synthetic position?

One can create it by purchasing or offloading the underlying financial instruments or/and derivatives. If traders buy many instruments with the same reward as allocating funds to a share, it is a synthetic underlying position. Likewise, individuals can create a synthetic option position in a nearly identical way.

2. Why is it called a synthetic position?

The term ‘synthetic’ is used for financial instruments engineered to recreate other instruments while changing vital features, such as cash flow and duration. Such a position allows traders to enter a position without utilizing any funds to actually buy or sell the security.

3. Is synthetic position good?

This trading option is good as it is a cost-efficient way for individuals to trade. Traders do not have to tie up the entire investment capital necessary to purchase an equivalent quantity of underlying security shares outright. One must note that synthetic long assets have unlimited risk. That said, they also come with unlimited profit potential.

This has been a guide to what is Synthetic Position. Here, we explain its types, examples, advantages, disadvantages, and reasons for using it. You can learn more about it from the following articles –

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