Synthetic Position

What is Synthetic Position?

Have you ever wondered what you would do if you could sell a car you don't own or buy a house that is no longer on the market? 

Hopefully not! As this is not possible, thinking about it would be completely irrational.

Not in the financial markets, though. In the equity markets, among others, there exists the choice to open a long (buy) or short (sell) position in a security and synthetically emulate the profit/loss associated with this position. 

Hence, the notion of a Synthetic Position. This is a way of emulating the playoff of one financial instrument through the purchase/sale of other financial instruments. A "synthetic version."

A trade option that mimics the characteristics of another similar position is called a synthetic position. To be more precise, the purpose of a synthetic position is to mimic the risk or reward profile of a comparable position.

There are two approaches to building a synthetic position in the world of options trading. To match a short or long position on the stock, one can combine many contracts or options to construct a synthetic position. The alternative strategy simulates a typical options trading strategy by using a series of options stocks or contracts.

The first thing we can explore is particularly what securities are traded in this manner and the process through which it's done. 

In particular, we will mainly focus on synthetic long and short positions in the stock, options, and puts market.

Types of Synthetic Positions

As previously discussed, synthetic positions are taken up and applied in many ways. 

Investors from all around the world use synthetic long and short positions to make money in this way. The instruments we discuss and that are used in this practice are stocks, call options, and put options.

1. Stocks quantify and track the value of the actual asset. For instance, an individual can own part of Apple by buying a share in the company, $AAPL. These stocks can be tracked and traded on various brokers and websites.
2. Call options are derivatives used when betting that the asset's value will appreciate. The contract allows the investor to purchase a certain amount of shares at a predetermined price; strike price. In addition, the contract is valid for a certain amount of time, known as the time to maturity. 
3. Put options, in contrast with call options, are derivatives used when betting the asset's value is going to depreciate. This contract gives the investor the right to sell the asset at a given price, the strike price, in a given period, again the time to maturity.
   • Call options and put options are purchased for a quantity known as the premium. If the investor was wrong, the only loss they'd make is this premium, as they won't exercise the option.

At-the-money call and put options are a special case of the respective derivatives with a strike price close to the asset's current value. 

Long Positions

A long position is simply buying something. For instance, an investor may open a long position of 10 shares in $SPY. This would merely be a situation in which an investor buys ten shares in $SPY. 

In other words, it is a situation in which an investor is betting the stock appreciates.

Hence, following this, we can merge this with synthetic positions and classify a range of synthetic long positions investors and funds use to make money.

1. Synthetic Long Stocks

Synthetic Long Stocks emulate the performance and any associated profit that comes with opening a long stock position. 

To do so, you would buy at the money calls on the relevant stock and then write at the money put on that stock. The respective amounts are calculated precisely based on how many shares an investor wishes to emulate. 

Doing this is very beneficial to the investor as it requires less initial margin and capital than buying the stock, as outright purchasing the stock would be much more expensive.

This works very well in mimicking the performance of the stock.

If the stock appreciates, the investor will make money due to the at-the-money calls; if the stock depreciates, the investor will lose money due to the sale of the at-the-money puts; if nothing changes, no money is made either way. 

Using this synthetic position very closely follows the profit/loss of the stock through the use of at-the-money calls and puts. 

2. Synthetic Long Calls

Synthetic long calls will emulate the performance of call options that can be purchased on a particular stock. 

To do so, an investor will look to buy actual shares and at-the-money puts on the asset. Similarly, each amount will be calculated rigorously depending on what the investor wants.

This will effectively mimic an option as the stock appreciating will reap the benefits the call would in case of this occurring. On the other hand, if the stock depreciates, investors will be protected due to the at-the-money puts purchased. 

Such a method is only used in the market when investors start to believe that a stock will appreciate, formerly having felt pessimistic and already owning puts; otherwise, this would prove a lot more expensive than outright buying calls and hence not very useful.

3. Synthetic Long Puts

Now to emulate the performance of purchasing a put in a particular stock, an investor would have to open a short position in the stock, hold a European call option, and hold a certain amount of money in the bank.

One would do this when initially they believe the stock will rise but then change their belief and feel it will depreciate. Then, they would short the stock to avoid loss on already-bought call options.

This will mimic the performance of the put very well as the short position, bet on it depreciating, will yield profits close to that of the put that could've been bought.

Short Positions

Unlike a long position, opening a short position references selling a good/service.

In context, an investor can short a stock when they close their existing long position by selling or leveraging a stock and selling it and buying it back later.

This is used when betting against a stock, as you believe the stock price will fall, so you may close your position to maximize profit or profit by selling now and buying back for less later.

Hence, similar to long positions, investors can formulate synthetic short positions too. We will focus on the latter meaning of shorting, as synthetically selling a stock you already own doesn't make much sense in a market.

1. Synthetic Short Stocks

To emulate the performance associated with shorting a stock, an investor would buy at-the-money put options and simultaneously short at-the-money call options. 

Buying put options will match the pessimistic belief and reward associated with shorting the stock. On the other hand, shorting the at-the-money call options will mimic the loss associated with shorting the stock if it happens to appreciate instead.

Using at-the-money calls and puts leads to profit and losses very close to that associated with shorting the stock.

Therefore, the use of this method mimics a short position very well.

Like before, a very big advantage to this is that the initial margin and overall maintenance margin required will be less than when shorting the stock.

Large hedge funds and proprietary trading firms often utilize this strategy when trying to make money, as it often leads to high profits with less risk of a margin call.

2. Synthetic Short Calls

In a situation where an investor already has a short position to put options on a stock as they believe it will appreciate. Following a change in beliefs that the stock will depreciate, the investor wants to go short on call options.

Instead of covering short positions on puts and then opening new short positions on the call options, the investor can go short on the stock and create a synthetic short call.

This acts as a short call position, as an increase in price would lead to losses due to the short position but hedged through the short position on the put options mimicking the short call.

If the price instead depreciates, the short position on the stock will lead to profits close to that of the short call but offset by the losses on the short puts to overall match the short position on the short call.

This is quite a tricky synthetic position, as the calculations required are precise. Hence, only often practiced by large institutions and experienced traders.

3. Synthetic Short Puts

A short put position would be used when of the belief that the stock price will rise, betting against the stock price depreciating.

If an investor believes the price is going to drop but then has a change in belief that the price is going to rise, the investor will turn to a synthetic short put.

This is because if the investor initially believed the stock price would drop, they would likely have open short positions in call options. Hence, the investor can buy the actual stock and create a synthetic short put instead of making losses on this position.

The short put is mimicked very well using this method. The long open position in the actual stock will follow the profit made by the short put closely. Likewise, the open short position in call options will offset losses from a price drop and ensure profits/losses closely follow.

Uses Of Synthetic Position

From above, we have seen some instances where synthetic positions are used. Predominantly, these positions are used when investors change their beliefs and don't want to lose money on existing positions.

For example, investors holding put options or call options can still use them to mimic the opposite with synthetic positions.

Additionally, synthetic positions in stocks may be used as an alternative to opening positions in the stock as it would require less initial funding and margin. This would mean less risk associated with a position providing a similar reward.

Hedge funds and experienced traders use these strategies daily to benefit from volatile markets and those in the market too slow to react to changes in the market.

Example Of Synthetic Position

Suppose a proprietary trading firm is invested in short positions to put options in stock A due to a strong belief that the asset will appreciate.

However, a speculative employee at the firm believes this asset will depreciate due to rumors about a vote of no confidence in the CEO of company A.

In contrast with the consensus, the firm trusts this employee; they decide to instead bet against stock A and so want to go short on call options in stock A.

However, the prop trading firm is heavily invested in short put options and does not want to close these positions as it would lead to a loss at the current market price. Instead, they task the employee with an appropriate solution to maximize profit.

The wise employee suggests the use of a synthetic short call instead.

Following rigorous calculations, the firm will now open short positions in stock A.

This action will lead to the creation of synthetic short calls, and hence the firm will be in place to benefit from the depreciation in a stock price and hence the value of the call options, as though they had short positions on those call options.

A week later, a vote of no confidence hits the news, and the stock's market price, and subsequent call options, collapse. However, the firm quickly begins to cover its positions and make a large profit due to well-crafted Synthetic Positions.

The calculations and projected payoffs are often graphed and analyzed before making trades.

Researched and authored by Shaun Desai | LinkedIn

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