Options have become a popular alternative among traders and investors looking to manage the market's volatile changes. Whether one wants to speculate on price swings or hedge current positions and portfolios, options provide a low-cost way to capitalise on non-linear payoffs. However, despite their adaptability, traders frequently encounter the issue of opportunity costs. This is where synthetic options step in.
Synthetic options represent an effective approach to reducing the negative opportunity costs associated with trading derivatives, namely options. In this article, we will talk about synthetic options, including their different types, uses, benefits, and drawbacks.
What are synthetic options
Synthetic options are portfolios or trading positions that mix numerous securities to imitate the position of another asset. The goal is to match the reward of the 'synthetic' position to that of the actual position. The put-call parity equation is the fundamental idea that underpins synthetic options. It provides a link between the prices of call and put options that share the same underlying asset. This connection is the foundation of synthetic options, allowing traders to create positions that are suited to their strategic objectives.
What are some types of synthetic options
- Synthetic long stock:
This method simulates owning the underlying stock without purchasing it directly. Traders purchase a call option and sell a put option. Purchasing a call option provides the right to buy the stock at a set price, but selling a put option requires you to buy it at the same price. This combination simulates owning the stock, gaining from price gains and minimising losses during price drops. - Synthetic short stock:
This strategy resembles short-selling a stock without really borrowing and selling it. Traders sell a call option and purchase a put option. Selling a call obligates you to sell the stock at a certain price, but purchasing a put provides protection by enabling you to sell the shares at the same price. Thus, traders earn if the stock price falls and lose if it increases. - Synthetic long call:
Traders can participate in a stock's upward growth without owning it directly by holding it and purchasing a put option. Holding the shares benefits from price rises, whilst the put option protects against decreases. This strategy simulates the profit potential of owning a long call option. - Synthetic short call:
This technique gains on a stock's decline or produces income from current ownership. Traders short-sell the stock and sell a put option. Short-selling entails borrowing and selling the stock, but selling a put obligates you to purchase it if exercised. This combination is equivalent to selling a call option, with profits if the stock price falls and losses if it increases. - Synthetic long put:
Traders may reduce downside risk without short-selling by selling the stock and purchasing a call option. Selling the stock profits from price decreases, whilst the call option protects against rises. This configuration simulates having a long put option. - Synthetic short put:
Traders sell a call option while retaining the shares, gaining if the stock price increases and losing if it drops. This strategy creates income or profits from stock holdings without buying more shares.
What are synthetic options used for
Synthetic options are useful in a variety of situations. Traders frequently use synthetic positions to alter existing holdings in reaction to changing market expectations without liquidating such positions. For example, owning a long stock position while also acquiring a put option might result in a synthetic call option that protects against downside risks while maintaining ownership of the underlying asset. Additionally, synthetic options simplify portfolio management by minimising the number of transactions required to modify positions, which improves operational efficiency.
Why use synthetic options trading strategies
The use of synthetic options serves several reasons.
- They enable investors to effortlessly change their current positions in response to changing market circumstances, maximising portfolio performance without the need for substantial restructuring.
- They promote efficient trading by lowering the transaction costs involved with changing positions, allowing traders to take advantage of market opportunities quickly.
- They provide arbitrage opportunities by leveraging mispricings between synthetic and genuine positions, potentially unlocking gains for experienced traders.
Advantages and disadvantages of synthetic options
Advantages:
- Risk management: Synthetic options help manage risks in your portfolio by offering different ways of hedging against future losses.
- Profit potential: These options mirror the profit potential of traditional options while reducing the risk of loss, providing a more balanced approach to investing.
- Efficiency: Synthetic options improve efficiency by streamlining portfolio adjustments, resulting in fewer transactions and reduced transaction costs.
- Arbitrage opportunities: Differences in price between synthetic and actual positions might create arbitrage opportunities, allowing traders to profit from market inefficiencies.
Disadvantages:
- Real-time losses: If the market swings against a synthetic position, traders may experience real-time losses, needing a strong exit plan to adequately manage risks.
- Complexity: Understanding and executing synthetic option strategies requires a thorough understanding of options trading fundamentals, which may provide difficulties for new traders.
- Liquidity concerns: Synthetic options may be less liquid than traditional options, making it difficult to execute transactions at desired prices.
- Opportunity costs: Failure to follow a disciplined money management plan may result in missed opportunities to convert failing synthetic positions to profitable ones, reducing overall profits.
Conclusion
In the toolbox of traders attempting to negotiate the intricate workings of the financial markets, synthetic options are a sophisticated yet indispensable weapon. For clever investors, synthetic options provide flexibility, efficiency, and profit potential as they may be used to replicate the payout of conventional options through alternate strategies.
