Synthetic Options

What are Synthetic Options?

Synthetic options are portfolios or tradingTrading & InvestingCFI's trading & investing guides are designed as self-study resources to learn to trade at your own pace. Browse hundreds of articles on trading, investing and important topics for financial analysts to know. Learn about assets classes, bond pricing, risk and return, stocks and stock markets, ETFs, momentum, technical positions holding a number of securitiesSecurityA security is a financial instrument, typically any financial asset that can be traded. The nature of what can and can’t be called a security generally depends on the jurisdiction in which the assets are being traded. 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 arbitrageArbitrageArbitrage is the strategy of taking advantage of price differences in different markets for the same asset. For it to take place, there must be a situation of at least two equivalent assets with differing prices. In essence, arbitrage is a situation that a trader can profit from 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.

What are Some Types of Synthetic Options?

It is possible to re-create option positions for just about any option using call optionsCall OptionA call option, commonly referred to as a "call," is a form of a derivatives contract that gives the call option buyer the right, but not the obligation, to buy a stock or other financial instrument at a specific price - the strike price of the option - within a specified time frame., put optionsPut OptionA put option is an option contract that gives the buyer the right, but not the obligation, to sell the underlying security at a specified price (also known as strike price) before or at a predetermined expiration date. It is one of the two main types of options, the other type being a call option., 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 optionsOptions: Calls and PutsAn option is a derivative contract that gives the holder the right, but not the obligation, to buy or sell an asset by a certain date at a specified price. with the underlying asset.

#1 Synthetic Long Stock

Traders will create a synthetic long stock position by entering into a long positionLong and Short PositionsIn investing, long and short positions represent directional bets by investors that a security will either go up (when long) or down (when short). In the trading of assets, an investor can take two types of positions: long and short. An investor can either buy an asset (going long), or sell it (going short). on a call option and a short positionLong and Short PositionsIn investing, long and short positions represent directional bets by investors that a security will either go up (when long) or down (when short). In the trading of assets, an investor can take two types of positions: long and short. An investor can either buy an asset (going long), or sell it (going short). 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-sellingLong and Short PositionsIn investing, long and short positions represent directional bets by investors that a security will either go up (when long) or down (when short). In the trading of assets, an investor can take two types of positions: long and short. An investor can either buy an asset (going long), or sell it (going short). the underlying stock.

#3 Synthetic Long Call

The synthetic long call positionCall OptionA call option, commonly referred to as a "call," is a form of a derivatives contract that gives the call option buyer the right, but not the obligation, to buy a stock or other financial instrument at a specific price - the strike price of the option - within a specified time frame. is created by holding the underlying stock and entering into a long put positionPut OptionA put option is an option contract that gives the buyer the right, but not the obligation, to sell the underlying security at a specified price (also known as strike price) before or at a predetermined expiration date. It is one of the two main types of options, the other type being a call option.. 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-sellingLong and Short PositionsIn investing, long and short positions represent directional bets by investors that a security will either go up (when long) or down (when short). In the trading of assets, an investor can take two types of positions: long and short. An investor can either buy an asset (going long), or sell it (going short). 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 investorInvestorAn investor is an individual that puts money into an entity such as a business for a financial return. The main goal of any investor is to minimize risk and 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 positionLong and Short PositionsIn investing, long and short positions represent directional bets by investors that a security will either go up (when long) or down (when short). In the trading of assets, an investor can take two types of positions: long and short. An investor can either buy an asset (going long), or sell it (going short). on a stock, and you are worried about downside riskRiskIn finance, risk is the probability that actual results will differ from expected results. In the Capital Asset Pricing Model (CAPM), risk is defined as the volatility of returns. The concept of “risk and return” is that riskier assets should have higher expected returns to compensate investors for the higher volatility and increased 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 positionCall OptionA call option, commonly referred to as a "call," is a form of a derivatives contract that gives the call option buyer the right, but not the obligation, to buy a stock or other financial instrument at a specific price - the strike price of the option - within a specified time frame. by buying a put optionPut OptionA put option is an option contract that gives the buyer the right, but not the obligation, to sell the underlying security at a specified price (also known as strike price) before or at a predetermined expiration date. It is one of the two main types of options, the other type being a call 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 arbitrageArbitrageArbitrage is the strategy of taking advantage of price differences in different markets for the same asset. For it to take place, there must be a situation of at least two equivalent assets with differing prices. In essence, arbitrage is a situation that a trader can profit from trading strategies. If you can identify a synthetic position that is mispriced with the actual position, then there is an opportunity to profitProfitProfit is the value remaining after a company’s expenses have been paid. It can be found on an income statement. If the value that remains. 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 profitProfitProfit is the value remaining after a company’s expenses have been paid. It can be found on an income statement. If the value that remains.

Additional Resources

Thank you for readings CFI’s article on synthetic options. If you would like to learn about related concepts, check out CFI’s other resources:

• Short CoveringShort CoveringShort covering, also called "buying to cover", refers to the purchase of securities by an investor to close a short position in the stock market. The process is closely related to short selling. In fact, short covering is part of short selling
• Directional Trading StrategiesDirectional Trading StrategiesDirectional options strategies are trades that bet on the up or down movement of the market. For example, if an investor believes the market is rising,
• Collar Option StrategyCollar Option StrategyA collar option strategy limits both losses and gains. The position is created with the underlying stock, a protective put, and a covered call.
• Option GreeksOption GreeksOption Greeks are financial measures of the sensitivity of an option’s price to its underlying determining parameters, such as volatility or the price of the underlying asset. The Greeks are utilized in the analysis of an options portfolio and in sensitivity analysis of an option