Synthetic Option Explained

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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.

Key Takeaways

  • 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.

Options Overview

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.

Synthetic Options

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.

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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.

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.

Put-Call Parity

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.

What is a Synthetic Option?

A synthetic option utilizes a mixture of various futures and standard options to come up with an option profile that will create the desired effect.

  • Written By: Malcolm Tatum
  • Edited By: Bronwyn Harris
  • Last Modified Date: 25 February 2020
  • Copyright Protected:
    2003-2020 Conjecture Corporation

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The synthetic option is a product that can be used to help control and minimize losses to a company which sometimes occur due to a change in interest rates or the exchange rate of currency. At the same time, the option does maintain some potential for realizing a gain as well as acting as a controlling agent.

A synthetic option functions by utilizing a mixture of various futures and standard options to come up with an option profile that will create the desired effect. One basic example of employing a synthetic option would be to purchase futures along with buying a number of puts. This more or less will achieve the same end as buying a call, but has the potential to lock in a margin on the purchase as well.

Essentially what occurs with a synthetic option is that the process of creating this type of option artificially creates a condition that mirrors a payoff of an underlying transaction or position that has a long call and a short put that have the same expiration and strike. Making sure the long call and the short put are always at the same strike will maintain the strike at the time of exercise or expiration, so there is no chance of a loss. At the same time, this process also does not limit the chance for realizing an increase on the transaction.

One of the advantages to employing a synthetic option is that there is always the chance to make some changes as you go along. For example, if market circumstances make it advantageous, the option could be structured with a slightly lower strike put and a slightly higher strike call. This would be a good way to progress if there is some trading taking place that falls in between the strike put and the strike call. The investor is then covering an acceptable range and can maneuver easier to meet whatever conditions may come into play regarding the stock. Also, this will help to ensure that the investor does not lose money even if the stock price falls slightly. As long as the stock price is above the lower strike put, the investment remains sound and does not decrease in value.

Use of the synthetic option is not for the novice. Understanding when and how to apply it in investing requires a sound and competent knowledge of the way that the stock markets work. For this reason, the strategy of a synthetic option is best undertaken only by those who have been trading for some time and know the market well, or only at the advice of a professional investment advisor.

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