The term synthetic is often used to describe a manmade object designed to imitate or replicate some other object. Futures and options traders can do the same thing by creating a trading vehicle through a combination of futures and options to replicate another trading instrument.
You may be asking yourself; why you would go through the hassle of mimicking an instrument instead of simply trading the original? The answer is simple, as the creator of the vehicle, we can customize it to better suit our needs as well as design it to better take advantage of the underlying market.
Through the creation of a synthetic position, you can actually decrease your delta as well as, in my opinion, increase the odds of success. Let's take a look at an example of a long synthetic put option.
Synthetic Long Put Option
Sell a Futures Contract
Buy an at-the-money Call Option
When to Use
- When you are very bearish, but want limited risk
- The more bearish you are the further from the futures (higher strike price) you can buy, although a true synthetic put involves an at the money call option
- This position is sometimes used instead of a straight long put due to its flexibility
- Like the long put this position gives you substantial leverage with unlimited profit potential and limited risk
- Profit potential is theoretically unlimited
- At expiration the break even is equal to the short futures entry price minus the premium paid
- Each point market goes below the break even profit increases by a point
What is at Stake
- Your loss limited to the difference between the futures entry prices and call strike price plus the premium paid for the option
- Your maximum loss occurs if the market is above the option strike price at expiration
A trader looking to profit from a decrease in profits but isn't confident enough in the speculation to sell a futures contract or even construct an aggressive option spread may look to a synthetic put. This strategy has nearly identical risk and reward potential as an outright put making it a potentially expensive proposition. However, if the volatility and premium is right it can be a great way to sell a futures contract, while retaining a piece of mind and the ability to easily adjust the position.
Click on image to enlarge!
In early 2007 the Treasury market had found itself caught in a trading range which spanned nearly a month. The lack of direction successfully imploded option premiums associated with the complex. According to hypothetical values available to us, at the end of March a trader may have been able to purchase a June 2007 T-Note 109 call option for about $750. At that point, the option would have had just over 3 months of time value and provided a relatively lengthy and inexpensive opportunity to insure a short futures trader against an adverse price move in the futures market. In other words, a trader could have simultaneously purchased the call and sold a futures contract knowing that their absolute risk is $750 plus any difference in the fill of the futures contract and the strike price of 109.
The same trader would be facing theoretically unlimited profit potential and three months in the market essentially worry free beyond the cost of the insurance (call option). With that said, in order for this trade to be profitable at expiration the futures price would have had to move enough in favor of the trader to overcome the premium paid for the option. In this case it is about 24 ticks. Assuming that the trader was able to sell the futures contract at 109 exactly, the profit zone would be at 108'08 (109 - 24/32).
The payout of this trade at expiration may be identical to a long put option, but the flexibility provided to the trader is unmatched. Unlike a long put, a synthetic long put can be pulled apart prior to expiration in an attempt to capitalize on market moves. Please note that doing so greatly alters the profit and loss diagram.
An example of an adjustment may be to take a profit on the short futures contract and hold the long call in hopes of a subsequent market rally and the possibility of being profitable on both the futures position and the long option. Or, should the trade go terribly wrong from the beginning a trader may look to take a profit on the long call and hold the short futures in hopes of a reversal. Doing so would eliminate the insurance of the long call and leave the trader open for unlimited risk on the upside, but may be justified if the circumstances are right.
*Futures and Options Trade Involves Substantial Risk of Loss and is Not Suitable for All Investors.
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