Synthetic OptionsSaachi Lodha
Options offer a very low-cost method to invest in with less capital, whether in currencies, trading futures, want to buy shares of a corporation. Options are the most common way to make profits from market swings. Synthetic options generally minimize problems as compared to vanilla options because generally synthetic options are less affected by problems of options. Volatility, decay, and strike price play a less important role in its ultimate outcome.
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How synthetic options work?
A synthetic call is also known as a married call or protective call. A synthetic call option begins with an investor buying or holding shares. The investor also purchases an at-the-money (ATM) put option on the same stock to protect it from depreciation. Investors generally think that this strategy can be considered similar to an insurance policy. This is done to protect the stock price against depreciation.
A synthetic put option is an options strategy that combines a short stock position with a long call option on that same stock to get a similar long put option and hence is called a synthetic long put. Similar to the synthetic call option an investor who has a short position in stock purchases an at-the-money (ATM) call option on that same stock to protect against appreciation in the stock price.
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Types of synthetic options:
Generally, there are about four synthetic positions, and they are used for a number of reasons.
- Synthetic Long Stock:
Synthetic long stock position involves emulating the potential results of owning actual stock by using trade options. To develop this, an individual has to buy at the stock money calls and then record at money puts of an equivalent stock. The price that is paid at the call is earned back by the money received once puts are written. This means that if the stock price fails to increase then there would be no loss or gain. Basically, it’s the same as holding stock. If the stock price increases then the money calls would generate a profit but if the price decreases then the puts would transform into a loss. The profit or loss is essentially equal to owning the stock.
- Synthetic Short Stock:
The synthetic short stock position is equivalent to short-selling existing stock. This position uses options only. Creating such a position calls for writing on relevant stocks at the money calls. Afterward, the same stock is bought at the money puts. The outcome is considered neutral if the stock does not increase in price. Once the calls are written the capital base needed to purchase puts is recovered. Thus, if the price of the stock drops, there would be again from the purchased puts. However, if the price increases, it would translate into a loss because of the written calls. The possible profit or loss is approximately equal to what the outcome would be if an individual short selling a stock.
- Synthetic Long Call:
The synthetic long call position is created when stocks are bought through a put option, which enables the purchase of relevant stock. The synthetic long call is only used when an individual owns put options and the price of the stock is expected to fall, but expectations change with the hope that the prices would increase. Rather than selling put options and then buying a call option, it is much easier to reconstruct a payoff characterized by obtaining essential stock and then refashioning a synthetic long call option. It would lead to a drop in the cost of transactions.
- Synthetic Short Call:
The synthetic short type of call requires short selling and writing a put on the essential stock. The positions reconstruct the features of a short call option. Rather than closing all short put positions and shorting all calls, the stockholder can simply recreate not possessing enough calls by shorting the relevant stocks. It will lead to a decrease in the cost of the transaction.
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 simplify decisions, make trading less expensive and help to manage positions more effectively
The concept of synthetic position seems puzzling, and some people may be wondering why someone would choose to go through it in the first place. Synthetic options are important where options trading is concerned, and there is a benefit from using them. Some people find it useful at one point or another. All that a person needs is to understand what they can do.
Author: Saachi Lodha
About the Author – A passionate professional with knowledge of Accounting and Finance and currently exploring Financial Risk Management (FRM) to gain knowledge and exposure. As a part of the FRM course also writing blogs to explore the field more and deep dive into the content.