Sometimes referred to as a synthetic long stock, a synthetic long asset is a strategy for options trading that is designed to mimic a long stock position. Traders create a synthetic long asset by purchasing at-the-money (ATM) calls and then selling an equivalent number of ATM puts with the same date of expiration.
Synthetic long assets come with an unlimited amount of risk; however, they also offer an unlimited potential profit. The synthetic long asset position is a more cost-effective way to trade without tying up all the investment capital required to buy an equivalent number of shares of the underlying stock outright. It can be created with a very small amount of capital because the cost of the call options is at least partially offset by the money received for selling the put options.
Synthetic positions (which includes synthetic long assets) are created using a combination of financial instruments – typically options – to mirror the same investment as an underlying asset.
Traders create synthetic long asset positions by buying at-the-money calls and then selling the same number of at-the-money puts; both the calls and the puts should have the same expiration date.
Just like a long stock position, synthetic long assets come with unlimited potential for profit or for loss (risk).
In order to better understand a synthetic long asset, it is first important to understand synthetic positions.
Synthetic positions are formed by using multiple financial instruments in place of a single, other financial instrument or asset. It is done, typically, by buying or selling derivatives of underlying financial instruments such as options. When the multiple instruments are combined, a synthetic position is created that essentially mimics the value of the underlying asset. Synthetic positions are most commonly created for equity market investments (stocks).
Advantages of Synthetic Positions
The primary and most important advantage of synthetic positions – versus buying stocks or selling short – is that the cost or margin requirement for the synthetic position is less than that of making an outright investment in the underlying asset.
A key distinction of synthetic positions is that they don’t involve dividend payments. The underlying security may have a dividend; however, with the creation of a synthetic position, traders/investors do not need to calculate dividend payments into their overall profit/loss.
A Double-Edged Sword
Synthetic long assets are double-edged swords because they come with unlimited potential for both profit and loss.
Much like long stock positions, synthetic long assets are not subject to a profit cap. As long as the underlying stock continues to go up, the trader stands to continue making a profit. The equation for profit looks something like this:
PROFIT = Profits realized in call options + Premiums received from the sale of put options – Premiums paid for call options and transaction costs
Profit is earned when the price of the underlying stock rises to higher than the strike price of the long call options bought prior to the options’ expiration date. The profit equals the long call options profit, plus the proceeds from the sale of put options, and minus the premiums paid for the call options and any transaction costs.
The other side of the sword is the fact that synthetic long positions come with unlimited potential for risk or loss. Significant losses can occur with synthetic long assets if the price of the underlying asset declines significantly. In such a scenario, the call options (assuming the underlying asset remains below the call option strike price) expire worthless, and being short, the put options expose the investor to potentially unlimited losses.
Because the total price (premium) for the call options purchased may be more than the proceeds received from selling the put options, traders often enter a synthetic long asset position with a debit. It means that even if the underlying stock doesn’t go down – if the price just remains relatively unchanged – the trader will still show a loss in the amount of the debit that was created from entering the position.
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