Synthetic Trading Strategies
In options trading, synthetic positions are primarily created to either emulate long or short stock holdings using only options, or emulate long or short options positions using a combination of stock and options. Traders would rarely set out to create a synthetic position, but they would use that position to move from one position to another when circumstances change.
The basic principle of synthetic options trading strategies is very similar and on this page we explain exactly what they are and the advantages that they offer. We also provide details on three of the most commonly used types. To get the most benefit out of this page you should have at least a basic understanding of synthetic positions.
- What are Synthetic Options Trading Strategies?
- Why use Synthetic Options Trading Strategies?
- Synthetic Straddle
- Synthetic Short Straddle
- Synthetic Covered Call
What Are Synthetic Options Trading Strategies?
The concept of synthetic options trading strategies is really quite simple. They are strategies that replicate the profit and loss profile of another strategy, but created in a different way. Typically, the strategy being replicated will involve multiple options positions and the synthetic strategy will use a combination of stocks and options.
The opposite can also be true, with the strategy being replicated involving a combination of stocks and options and the synthetic strategy using multiple options positions.
These strategies aren't as complicated as many traders believe them to be, and they offer a couple of clear advantages in certain circumstances.
Why Use Synthetic Options Trading Strategies?
There are two common reasons for using these strategies. First, you would use them as a simple way to try and profit if your outlook on an existing position changes, because you will see from two of the examples below that they can be used to adjust an existing stock position to try and profit from a period of volatility, or to try and profit from a period of stability.
Second, you would use them because there are typically fewer transactions involved in turning an existing position into a synthetic position than there would be in closing the position and creating the relevant position from scratch. By making fewer transactions you would have to pay less in commissions to your broker.
The advantages are really that simple; they are an easy way to adjust an existing position and they can save you money.
The synthetic straddle emulates the strategy known as the long straddle. A long straddle would usually be created if your outlook was volatile i.e. you expected the underlying security to move significantly in price, but you weren't sure in which direction it would move. It's created by buying an equal number of the same calls and puts and it enables you to make profits regardless of which way the price of the underlying security moves, provided it moves at least a certain amount.
The synthetic straddle also makes profits in a similiar way, but it also uses a combination of stocks and options. There are actually two ways to create one.
The first is by owning stocks and also owning twice the amount of at the money puts based on that stock, and the second is by being short on stock and owning twice the amount of at the money calls based on that stock. For example, if you owned 100 shares of Company X stock and also 2 at the money puts (each one covering 100 shares) based on that stock, then you would basically have created a synthetic straddle.
As a general rule, you wouldn't create a synthetic straddle from scratch because you want to change an existing position into a straddle. Typically, you would only create one if you hold either a long stock position or a short stock position and you believe that the stock is entering a period of volatility and you expect it to move dramatically in price but you aren't sure in which direction.
Rather than selling your long stock position or buying back your short position and then creating a long straddle (which would involve multiple transactions and higher commissions), you can simply buy the correct amount of the relevant options to create a synthetic straddle and you'll have the same potential profits and the same potential losses as you would with a long straddle.
Synthetic Short Straddle
The synthetic short straddle is the equivalent of the short straddle, which is used when your outlook is neutral i.e. you expect the underlying security to be stable in price. The short straddle is created by writing an equal number of the same calls and puts and will return a profit if the underlying security doesn't move in price or only moves within a tight range.
The synthetic short straddle would also return a profit in the same way, but it's created with a combination of stocks and options. It can be made in two ways. One is by owning stocks and being short on twice the amount of calls based on that stock. The second is by being short on stocks and also being short on twice the amount of put options based on that stock.
As an example: if you owned 100 stocks in Company X and then wrote 2 calls (each one covering 100 shares), then you would have created a synthetic short straddle.
The primary use of this strategy is for when you have an existing stock position, short or long, and you believe that the stock is unlikely to move in price. Rather than exiting your stock position, you could keep it open and write the necessary options contracts to create a synthetic short straddle. You would then be able to profit from the stock price not moving, but you would incur less commission charges than you would if you chose to exit your stock position and then create a short straddle.
Synthetic Covered Call
This is a strategy that is used to replicate the strategy known as the covered call, which is a popular, and straightforward, strategy that is created with a combination of a long stock position and a short call options position. You would typically employ the covered call strategy if you wanted to own a stock for the long term, but expected the price of that stock to remain relatively stable in the short term. By writing calls based on the stock, usually with a short time until expiration, you will profit if the stock doesn’t move in price and also have some limited protection if it falls in price.
To create a synthetic covered call, the long stock position is replaced by deep in the money calls based on that stock that have at least a few months until expiration; you still should write calls with a short time until expiration. Owning deep in the money calls with a long time until expiration has a profit and loss profile very similar to actually owning the stock, so the calls bought are basically just a straight replacement for the long stock position. As such, this is a very simple strategy and certainly one of the more popular ones.
You would normally look to use this strategy in similar circumstances to when you would consider using a covered call i.e. you believe the price of a stock will increase in the long term but be relatively stable in the short term. The biggest difference is that you would usually employ the covered call if you already owned the stock and then decided to try and profit from short term stability by writing the calls options against it.
You would be more likely to create the synthetic covered call from scratch, when you have an outlook that is neutral in the short term but bullish in the long term. The biggest advantage it has over the covered call is that it requires a smaller investment, because the cost of the deep in the money calls is less than the corresponding long stock position would be.