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.

For instance, a trader can create a position with puts and calls that looks identical to a long stock position (a position that has a risk curve sloping upward to the right): go long (buy) a call and go short (sell) a put.

With stock calls and puts, we have six basic strategies: long or short each of the three. Then, with a little imagination, we can mix and match those same stocks, calls and puts to create synthetic, or artificial, versions of the same risk graphs.

Before we look at various synthetic trades, let's examine why we might actually enter a synthetic position as opposed to the obviously more simple direct position. A trader might prefer a synthetic position to the original for at least five reasons:

  1. The synthetic position is less costly, either in cash or margin requirements.

  2. Entering the synthetic position reduces commissions as opposed to entering the basic position.

  3. A synthetic position actually improves some element(s) of the base position that you are looking to enter.

  4. The synthetic position will permit easier adjustments to the trade as conditions change.

  5. You inadvertently end up in a synthetic position as part of your trading activities.

1. Costs

Sometimes 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. Commissions

The 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 Elements

A 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 Adjustments

The 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 Strategy

Finally, 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
Source: Optionetics

Although each basic position can be recreated synthetically, as traders we don't necessarily want to go out and enter such positions. Just as in all trades, we have to examine the risks and rewards of each position and decide just which trades fit our risk tolerances and our belief in the market.

For instance, if we wouldn't necessarily short a stock, then a synthetic short stock position (short call and long put) would also not make sense, probably. In many cases, though, if we're trading a stock and something goes against us -- we are assigned on something, we can step back and examine just what our net position now looks like. Often, it will be a recognizable position, one that we might decide (given the changed circumstances) that we aren't unhappy with or even one that, with a minor adjustment, can be turned into another trade, another risk curve, that we does make us quite happy.
By Andrew Neyens, staff writer and trading strategist at Optionetics.com. Send him email at aneyens@optionetics.com.

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