Synthetic options are portfolios or trading positions holding a number of securities that when taken together, emulate another position. The payoff of the emulated, synthetic position and the actual position should, in theory, be identical. If the prices for these two are not identical then an arbitrage opportunity would exist in the market. Assessing synthetic options can be used to determine what the price of a security should be. In practice, traders often create synthetic positions to adjust existing positions.
Quick Summary of Points
A synthetic option is a trading position holding a number of securities that when taken together, emulate another position
The basic synthetic positions include: synthetic long stocks, synthetic short stocks, synthetic long calls, synthetic short calls, synthetic long puts, and synthetic short puts
Synthetic positions can be used to alter an existing position, reduce the number of necessary transactions to change a position, and to identify option mispricing in the market
What are Some Types of Synthetic Options?
It is possible to re-create option positions for just about any option using call options, put options, and the underlying asset. The basic synthetic positions include: synthetic long stocks, synthetic short stocks, synthetic long calls, synthetic short calls, synthetic long puts, and synthetic short puts. The following graphs show how these synthetic positions can be created by using the underlying asset, and options with the underlying asset.
#1 Synthetic Long Stock
Traders will create a synthetic long stock position by entering into a long position on a call option and a short position on a put option. The graph below shows how the payoff of a long call and short put are equal to a long stock position.
#2 Synthetic Short Stock
Instead of directly shorting a stock, an investor may create a synthetic short stock position by entering into a short position on the call and a long position on the put. The below graph shows how this portfolio is equal to short-selling the underlying stock.
#3 Synthetic Long Call
The synthetic long call position is created by holding the underlying stock and entering into a long put position. Below shows that the payoff from holding the synthetic call is equal to entering into a long call position.
#4 Synthetic Short Call
A synthetic short call position is created by short-selling the stock, and entering into a short position on the put option. The below graph shows how these two transactions are equal to entering into a short call position.
#5 Synthetic Long Put
The synthetic long put position is created by short-selling the underlying stock, and entering into a long position on the call option. The below graph shows that these two positions will equate to holding a long put option position.
#6 Synthetic Short Put
The synthetic short put position is created by holding the underlying stock and entering into a short position on the call option. Below shows that the payoff of these two positions will be equal to a short position on the put option.
What are Synthetic Options Used for?
Synthetic options can be used for a number of reasons. One reason an investor will enter into a synthetic position is to alter an already existing position when expectations change. This can allow for a position to be altered without closing the pre-existing position. For example, if you are already holding a long position on a stock, and you are worried about downside risk, you might enter into a synthetic call option position by buying a put option.
By creating the synthetic call, you can still hold onto the underlying stock. This can be important if there are other considerations such as a need to hold ownership in the company.
Using synthetic positions can also reduce the number of transactions you need to make, to change your position. For example, take the above situation of changing a long position on the stock to a synthetic call position by buying a put option. If you were a trader and wanted to change your position from a long stock position to a call position without the use of a synthetic position you would have to sell the stock and buy the call option. This uses two transactions rather than just buying the put option.
Using fewer transactions can be important in efficient trading strategies. Each transaction will generally come at a cost, so it makes sense to want to reduce the number of transactions whenever possible.
Another reason synthetic options can be used are to employ arbitrage trading strategies. If you can identify a synthetic position that is mispriced with the actual position, then there is an opportunity to profit. For example, if a call option costs more than the synthetic call option, you can short the call option and buy the synthetic call option and profit.
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