According to my dictionary, a synthetic is something that is not real or genuine. In trading, this equates to a position whose risk graph looks like a particular trade, but is made up of a combination of different elements.
- The synthetic position is less costly, either in cash or margin requirements. Entering the synthetic position reduces commissions as opposed to entering the basic position. A synthetic position actually improves some element(s) of the base position that you are looking to enter. The synthetic position will permit easier adjustments to the trade as conditions change. You inadvertently end up in a synthetic position as part of your trading activities.
1. CostsSometimes a synthetic position ends up being less costly, simply from the way in which the trade is put together and the method by which margin requirements are calculated. For instance, in the aforementioned example of the synthetic version of the long stock position (long a call and short a put), you'll find both that it costs less cash to enter the position (often even getting a credit upon entry), and that the margin requirements are less than would be required to actually purchase the stock. Looking for a real-life example of the synthetic long stock position, I called my broker to inquire about a synthetic version of going long IBM ( IBM) stock. At the time, IBM was selling for $73.32. The October 75 calls could be purchased for $5, and the October 75 puts could be sold for $6.50. Thus, we could either buy the stock for $73.32 a share ($73,320 debit to our account for 1,000 shares) or simultaneously purchase a call for $5.00 and sell a put for $6.50. The synthetic long stock position would actually net a $1,500 credit (using 10 contracts) as opposed to the $73,320 debit for the outright purchase of stock. But nothing is free in this business, and the broker would require money to be set aside in our account to offset the potential downside to the position. In fact, the total margin required to enter this synthetic long position in IBM would be $19,000, per my broker's margin department. There were also various house rules, including one about the minimum account size. In other words, if this were the only transaction I was doing, I'd probably need additional cash in my account above the $19,000 minimum margin requirement. In any case, the bottom line was that for the simple long stock position, I would need $36,660 cash, plus I'd have to borrow another $36,660 from the brokerage house (paying interest) to enter the trade. For the same risk curve, only using a synthetic position, I would actually receive $1,500 cash into my account, and would only have to set aside $19,000 in that account to open the trade! (By the way, the $19,000 margin required in my account would be actual cash set aside, not borrowed, so there would be no interest charges on the synthetic position, whereas there would be interest charges on the long stock borrowings -- still another savings to the synthetic position.) Rather than going long the stock or entering the equivalent synthetic position, simply purchasing the call would be an even better position in most cases. The risk is limited on the downside, and although the actual cost would be $5,000 (the cost of the 10 calls), there would be no additional margin requirement.
2. CommissionsThe second reason for a synthetic position is that commissions may be reduced. At first glance, this may seem a bit strange, but consider morphing an existing position into something else. If, for instance, you somehow ended up with a short put and wanted to eliminate the restriction on the position's upside potential, you could convert into a long stock position by simply purchasing a call: one commission. On the other hand, if you were to buy back the short put and simultaneously purchase a long position in the stock, you would be faced with two commissions.
3. Improved ElementsA synthetic position may improve the various elements over the base position, depending on what you're trying to accomplish. By using various combinations, you could actually reduce or increase time decay, increase or decrease volatility, etc. -- all depending on what works best for your trade. Of course, each of these advanced maneuvers will come with offsetting negatives: increased costs, increased risks or changes in one or more of the other variables that affect the profitability of a given trade.
4. Easier AdjustmentsThe fourth concept, easier adjustments, comes about simply from the make-up of the given trade. In the case of a long synthetic stock position, it can quickly be converted from the base position to a combination of a long call and a bull put spread by simply purchasing a put with a lower strike than the one sold. For instance, in the IBM example, purchasing a put anywhere below the $75 strike will convert that trade into a bull put spread and the remaining long call. Note: Adjustments are an advanced technique used to enhance the returns of a basic trade.
5. Inadvertent StrategyFinally, you can inadvertently end up in a synthetic position. One of the easiest to understand is the synthetic call, a position whose risk graph looks like a call, but is instead made up of a put and stock. If you were trading bull put spreads (long a given strike put and short a put with a higher strike, same underlying and same expiration month), you could see the stock take a sudden dip and get assigned on your short put position. This means that you're required to purchase 100 shares of stock at the strike price of the short put for each put you're assigned. With IBM, you could have entered a bull put spread by purchasing the October 70 put for $4.30 and selling the October 75 put for $6.50, or a credit of $2.30 per share, or $230 per spread. If the stock dipped down and you were assigned on your short put at some point, you'd then have to purchase the stock for the $75 strike of the short put. You'd be left with 100 shares of stock and your long October 70 put. No matter how low the stock falls from this point, you'd be able to sell it for $70 (the strike of your long put), and as the stock price climbs, there's no upper limit -- exactly the look of a long call. So if you believe that IBM has a good chance of not only recovering, but also moving strongly above the $70 level, you might choose to remain in the synthetic call. After all, the most you can lose between now and the third Friday in October is the $270 risk per spread that you started out with. ( Original: $5.00 risk of spread minus $2.30 credit equals $2.70 net risk. Now: $75 paid for stock minus $2.30 credit upon entering trade, minus $70 for exercising the long put equals $2.70 net risk.)
|Rounding the Bases |
Here are each of the various base positions, their synthetic counterparts and comments on the position
|Base Position||Synthetic Equivalent||Comments on the Synthetic Position|
|Long stock||Long call and short put||Generally requires little or no cash to enter, less margin, and no borrowings|
|Short stock||Short call and long put||Generally requires little or no cash to enter, less margin and no borrowings|
|Long call||Long stock and long put||A common result of a bull put spread if the stock drops precipitously|
|Short call||Short stock and short put||A very risky position, either in the base configuration or in the synthetic equivalent. It will probably require significant margin to enter, especially if your brokerage house is unsophisticated in option risk|
|Long put||Short stock and long call||A common result of a bull call spread if the stock rises significantly|
|Short put||Long stock and short call||A very common position, also known as a covered call. As the covered call is simply the equivalent of a short put, the risk inherent in the trade should be obvious|