All about Synthetic Options Spread
Options are one of the popular financial instruments that traders use to earn profits. Several strategies can help investors purchase or sell stock options and make profits. The synthetic options spread is one such strategy that helps investors imitate the features of another position using a combination of short and long positions.
To learn more about synthetic options and how they are used in the market, keep reading.
What Are Synthetic Options?
A synthetic option is a trading strategy that allows traders to recreate risk profiles and payoffs of another asset. It involves using a combination of different options and assets to replicate or mirror the position of another financial instrument. As a result, the payouts for a synthetic position and an actual position are the same. If this does not happen, it opens up chances for arbitrage opportunities.
A trader can avoid several obstacles by choosing synthetic options rather than plain ones. Traders usually create synthetic positions to adjust the existing positions. Furthermore, factors like market volatility, strike price, and expiration date have lesser impact on the returns a trader can earn from synthetic options. Synthetic positions also tend to be very flexible, allowing traders to swap positions at any time.
Why Do Traders Use Synthetic Options Spread?
In synthetic options spreads, a trader combines different positions such as long, short, call or put with a cash position to create a synthetic option. Such positions are designed to be identical to the position of an individual futures or options contract.
Here are a few reasons why traders use synthetic options spread.
- As stated earlier, synthetic positions can come in handy when adjusting the existing positions. For instance, you have a long position on a particular stock. However, you anticipate a downside risk in the near term.
To reduce any chance of losses, you can opt for a synthetic call option by buying a put option. The synthetic call will allow you to hold the underlying asset. This is helpful if you do not wish to lose ownership of stocks of a certain company.
- These options are highly flexible. When the market conditions change, you can quickly swap positions without having to close older positions. You also do not need to change the entire position to make minor adjustments.
- Synthetic options can also help to initiate an arbitrage strategy. A misplaced synthetic position offers the potential to earn you relatively low-risk profits. For instance, if a call option is more expensive than its synthetic call option, you can short the former and buy the latter to make a quick profit.
- Creating synthetic options can also reduce the number of transactions you would need to make to alter your position. Each transaction generally comes at a cost. It also helps reduce the quantum of transactions which assists in efficient trading.
What Are the Types of Synthetic Options?
There are two types of synthetic options. Both of these require a combination of cash and future positions with options. Out of them, cash or future position makes a primary position and the option holds a protective position. Let’s take a look at the types of synthetic options.
- Synthetic Long Put
This is an options trading strategy that combines a short stock position with a long call option. This is done on the same stock to recreate a long put option. As a result, this strategy is called a synthetic long-put option.
Investors with a short position can buy a stock with an At-The-Money call option on the same stock as a shield against any appreciation of stock price.
- Synthetic Long Call
This option is called the synthetic call option. This begins when an investor purchases shares. As a protection, an investor also purchases an at-the-money put option at that very stock. This helps them shield their investments from the depreciation of a stock’s price.
This strategy hedges investors from the adverse effects of a price drop. The synthetic call option is also called the married call or protective call option.
What Are the Benefits of Synthetic Options?
Here are a few notable advantages of using synthetic options that you must know as a trader:
- These options act as a cushion against an unlimited risk of cash or futures positions. Synthetic long puts are ideal for bearish conditions as it limits potential losses.
- It mimics the unlimited profit potential and the loss potential of regular options without the restrictions of a particular strike price.
- Synthetic options allow traders to enjoy earnings from future positions and options while lowering the chances of risks.
What Are the Disadvantages of Synthetic Options?
Besides the above benefits, there are certain disadvantages of synthetic options that a trader must remember.
- When the market moves against a future or cash position, it is likely to lose money for traders in real time. One can only make the money move up with options by purchasing an at-the-money option. However, these are more expensive than out–of–money options.
- Traders also require a sound strategy to exit from a cash or future position. Without this, they can lose an opportunity to shift from one sinking synthetic position to a profitable one.
Synthetic options possess the ability to make trading less expensive, simplify decisions and help effectively manage positions. As these options are combinations of multiple options, traders receive a lot of flexibility when formulating strategies. However, novice traders must acquire sufficient knowledge and consult financial experts before using synthetic options spreads.
Frequently Asked Questions
1. Are synthetic long assets risky?
Although synthetic long assets come with the potential for unlimited profits, there are high risks of losses. But it is an effective way to trade without opting for investment capital to buy an equivalent number of shares of the underlying stocks.
2. Are synthetic calls good for trading?
Like long calls, synthetic calls also have the potential for unlimited profits as there is no ceiling for underlying stock price appreciation. However, the profits tend to decrease by the premium paid for purchasing put options.
3. What is the synthetic call strategy?
This is a strategy that traders use to stay in a bullish position with underlying assets for a long time. Synthetic call strategy provides the potential for unlimited rewards with limited risks.
4. What is the major advantage or disadvantage of synthetic calls?
Synthetic calls offer the potential for long term profits. However, if the underlying assets’ price goes down, traders can incur major losses on exercising options.