Understanding Synthetic Positions
The basic definition of synthetic positions is that they are trading positions created to emulate the characteristics of another position. More specifically, they are created in order to recreate the same risk and reward profile as an equivalent position. In options trading, they are created primarily in two ways.
You can use a combination of different options contracts to emulate a long position or a short position on stock, or you can use a combination of option contracts and stocks to emulate a basic options trading strategy. In total, there are six main synthetic positions that can be created, and traders use these for a variety of reasons.
The concept may sound a little confusing and you may even be wondering why you would need or want to go through the trouble of creating a position that is basically the same as another one. The reality is that synthetic positions are by no means essential in options trading, and there's no reason why you have to use them.
However, there are certain benefits to be gained, and you may find them useful at some point. On this page, we explain some of the reasons why traders do use those positions, and we also provide details on the six main types.
- Why use Synthetic Positions?
- Synthetic Long Stock
- Synthetic Short Stock
- Synthetic Long Call
- Synthetic Short Call
- Synthetic Long Put
- Synthetic Short Put
Why Use Synthetic Positions?
There are a number of reasons why options traders use synthetic positions, and these primarily revolve around the flexibility that they offer and the cost saving implications of using them. Although some of the reasons are unique to specific types, there are essentially three main advantages and these advantages are closely linked. First, is the fact that synthetic positions can easily be used to change one position into another when your expectations change without the need to close out the existing ones.
For example, let’s imagine you have written calls in the expectation that the underlying stock would drop in price over the coming weeks, but then an unexpected change in market conditions leads you to believe that the stock would actually increase in price. If you wanted to benefit from that increase in the same way you were planning to benefit from the fall, then you would need to close your short position, possibly at a loss, and then write puts.
However, you could recreate the short put options position by simply buying a proportionate amount of the underlying stock. You have actually created a synthetic short put as being short on calls and long on the actual stock is effectively the same as being short on puts. The advantage of the synthetic position here is that you only had to place one order to buy the underlying stock rather than two orders to close your short call position and secondly to open your short put position.
The second advantage, very similar to the first, is that when you already hold a synthetic position, it's then potentially much easier to benefit from a shift in your expectations. We will again use an example of a synthetic short put.
You would use a traditional short put (i.e. you would write puts) if you were expecting a stock to rise only a small amount in value. The most you stand to gain is the amount you have received for writing the contracts, soit doesn’t matter how much the stock goes up; as long it goes up enough that the contracts you wrote expire worthless.
Now, if you were holding a short put position and expecting a small rise in the underlying stock, but your outlook changed and you now believed that the stock was going to rise quite significantly, you would have to enter a whole new position to maximize any profits from the significant rise.
This would typically involve buying back the puts you wrote (you may not have to do this first, but if the margin required when you wrote them tied up a lot of your capital you might need to) and then either buying calls on the underlying stock or buying the stock itself. However, if you were holding a synthetic short put position in the first place (i.e. you were short on calls and long on the stock), then you can simply close the short call position and then just hold on to the stock to benefit from the expected significant rise.
The third main advantage is basically as a result of the two advantages already mentioned above. As you will note, the flexibility of synthetic positions usually means that you have to make less transactions. Transforming an existing position into a synthetic one because your expectations have changed typically involves fewer transactions than exiting that existing position and then entering another.
Equally, if you hold a synthetic position and want to try and benefit from a change in market conditions, you would generally be able to adjust it without making a complete change to the positions you hold. Becaus of this, synthetic positions can help you save money. Fewer transactions means less in the way of commissions and less money lost to the bid ask spread.
Synthetic Long Stock
A synthetic long stock position is where you emulate the potential outcomes of actually owning stock using options. To create one, you would buy at the money calls based on the relevant stock and then write at the money puts based on the same stock.
The price that you pay for the calls would be recouped by the money you receive for writing puts, meaning that if the stock failed to move in price you would neither lose nor gain: the same as owning stock. If the stock increased in price, then you would profit from your calls, but if it decreased in price, then you would lose from the puts you wrote. The potential profits and the potential losses are essentially the same as with actually owning the stock.
The biggest benefit here is the leverage involved; the initial capital requirements for creating the synthetic position are less than for buying the corresponding stock.
Synthetic Short Stock
The synthetic short stock position is the equivalent of short selling stock, but using only options instead. Creating the position requires the writing of at the money calls on the relevant stock and then buying at the money puts on the same stock.
Again, the net outcome here is neutral if the stock doesn't move in price. The capital outlay for buying the puts is recouped through writing the calls. If the stock fell in price, then you would gain through the purchased puts, but if it increased in price, then you would lose from the written calls. The potential profits and the potential losses are roughly equal to what they would be if you were short selling the stock.
There are two main advantages here. The primary advantage is again leverage, while the second advantage is related to dividends. If you have short sold stock and that stock returns a dividend to shareholders, then you are liable to pay that dividend. With a synthetic short stock position you don't have the same obligation.
Synthetic Long Call
A synthetic long call is created by buying put options and buying the relevant underlying stock. This combination of owning stocks and put options based on that stock is effectively the equivalent of owning call options. A synthetic long call would typically be used if you owned put options and were expecting the underlying stock to fall in price, but your expectations changed and you felt the stock would increase in price instead. Rather than selling your put options and then buying call options, you would simply recreate the payoff characteristics by buying the underlying stock and creating the synthetic long call position. This would mean lower transaction costs.
Synthetic Short Call
A synthetic short call involves writing puts and short selling the relevant underlying stock. The combination of these two positions effectively recreates the characteristics of a short call options position. It would usually be used if you were short on puts when expecting the underlying stock to rise in price and then had reason to believe the stock would actually fall in price.
Instead of closing your short put options position and then shorting calls, you could recreate being short on calls by short selling the underlying stock. Again, this means lower transaction costs.
Synthetic Long Put
A synthetic long put is also typically used when you were expecting the underlying security to rise, and then your expectations change and you anticipate a fall. If you had bought call options on stock that you were expecting to rise, you could simply short sell that stock. The combination of being long on calls and short on stocks is roughly the same as holding puts on the stock – i.e. being long on puts.
When you already own calls, creating a long put position would involve selling those calls and buying puts. By holding on to the calls and shorting the stock instead, you are making fewer transactions and therefore saving costs.
Synthetic Short Put
A normal short put position is usually used when you are expecting the price of an underlying stock increase by moderate amount. The synthetic short put position would generally be used when you had previously been expecting the opposite to happen (i.e. a moderate drop in price).
If you were holding a short call position and wanted to switch to a short put position, you would have to close your existing position and then write new puts. However, you could create a synthetic short put instead and simply buy the underlying stock. A combination of owning stock and having a short call position on that stock essentially has the same potential for profit and loss as being short on puts.