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Understanding Synthetic Positions
The basic definition of synthetic positions is that they are trading positions created to emulate the characteristics of another position. More specifically, they are created in order to recreate the same risk and reward profile as an equivalent position. In options trading, they are created primarily in two ways.
You can use a combination of different options contracts to emulate a long position or a short position on stock, or you can use a combination of option contracts and stocks to emulate a basic options trading strategy. In total, there are six main synthetic positions that can be created, and traders use these for a variety of reasons.
The concept may sound a little confusing and you may even be wondering why you would need or want to go through the trouble of creating a position that is basically the same as another one. The reality is that synthetic positions are by no means essential in options trading, and there’s no reason why you have to use them.
However, there are certain benefits to be gained, and you may find them useful at some point. On this page, we explain some of the reasons why traders do use those positions, and we also provide details on the six main types.
- Why use Synthetic Positions?
- Synthetic Long Stock
- Synthetic Short Stock
- Synthetic Long Call
- Synthetic Short Call
- Synthetic Long Put
- Synthetic Short Put
Why Use Synthetic Positions?
There are a number of reasons why options traders use synthetic positions, and these primarily revolve around the flexibility that they offer and the cost saving implications of using them. Although some of the reasons are unique to specific types, there are essentially three main advantages and these advantages are closely linked. First, is the fact that synthetic positions can easily be used to change one position into another when your expectations change without the need to close out the existing ones.
For example, letвЂ™s imagine you have written calls in the expectation that the underlying stock would drop in price over the coming weeks, but then an unexpected change in market conditions leads you to believe that the stock would actually increase in price. If you wanted to benefit from that increase in the same way you were planning to benefit from the fall, then you would need to close your short position, possibly at a loss, and then write puts.
However, you could recreate the short put options position by simply buying a proportionate amount of the underlying stock. You have actually created a synthetic short put as being short on calls and long on the actual stock is effectively the same as being short on puts. The advantage of the synthetic position here is that you only had to place one order to buy the underlying stock rather than two orders to close your short call position and secondly to open your short put position.
The second advantage, very similar to the first, is that when you already hold a synthetic position, it’s then potentially much easier to benefit from a shift in your expectations. We will again use an example of a synthetic short put.
You would use a traditional short put (i.e. you would write puts) if you were expecting a stock to rise only a small amount in value. The most you stand to gain is the amount you have received for writing the contracts, soit doesnвЂ™t matter how much the stock goes up; as long it goes up enough that the contracts you wrote expire worthless.
Now, if you were holding a short put position and expecting a small rise in the underlying stock, but your outlook changed and you now believed that the stock was going to rise quite significantly, you would have to enter a whole new position to maximize any profits from the significant rise.
This would typically involve buying back the puts you wrote (you may not have to do this first, but if the margin required when you wrote them tied up a lot of your capital you might need to) and then either buying calls on the underlying stock or buying the stock itself. However, if you were holding a synthetic short put position in the first place (i.e. you were short on calls and long on the stock), then you can simply close the short call position and then just hold on to the stock to benefit from the expected significant rise.
The third main advantage is basically as a result of the two advantages already mentioned above. As you will note, the flexibility of synthetic positions usually means that you have to make less transactions. Transforming an existing position into a synthetic one because your expectations have changed typically involves fewer transactions than exiting that existing position and then entering another.
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Equally, if you hold a synthetic position and want to try and benefit from a change in market conditions, you would generally be able to adjust it without making a complete change to the positions you hold. Becaus of this, synthetic positions can help you save money. Fewer transactions means less in the way of commissions and less money lost to the bid ask spread.
Synthetic Long Stock
A synthetic long stock position is where you emulate the potential outcomes of actually owning stock using options. To create one, you would buy at the money calls based on the relevant stock and then write at the money puts based on the same stock.
The price that you pay for the calls would be recouped by the money you receive for writing puts, meaning that if the stock failed to move in price you would neither lose nor gain: the same as owning stock. If the stock increased in price, then you would profit from your calls, but if it decreased in price, then you would lose from the puts you wrote. The potential profits and the potential losses are essentially the same as with actually owning the stock.
The biggest benefit here is the leverage involved; the initial capital requirements for creating the synthetic position are less than for buying the corresponding stock.
Synthetic Short Stock
The synthetic short stock position is the equivalent of short selling stock, but using only options instead. Creating the position requires the writing of at the money calls on the relevant stock and then buying at the money puts on the same stock.
Again, the net outcome here is neutral if the stock doesn’t move in price. The capital outlay for buying the puts is recouped through writing the calls. If the stock fell in price, then you would gain through the purchased puts, but if it increased in price, then you would lose from the written calls. The potential profits and the potential losses are roughly equal to what they would be if you were short selling the stock.
There are two main advantages here. The primary advantage is again leverage, while the second advantage is related to dividends. If you have short sold stock and that stock returns a dividend to shareholders, then you are liable to pay that dividend. With a synthetic short stock position you don’t have the same obligation.
Synthetic Long Call
A synthetic long call is created by buying put options and buying the relevant underlying stock. This combination of owning stocks and put options based on that stock is effectively the equivalent of owning call options. A synthetic long call would typically be used if you owned put options and were expecting the underlying stock to fall in price, but your expectations changed and you felt the stock would increase in price instead. Rather than selling your put options and then buying call options, you would simply recreate the payoff characteristics by buying the underlying stock and creating the synthetic long call position. This would mean lower transaction costs.
Synthetic Short Call
A synthetic short call involves writing puts and short selling the relevant underlying stock. The combination of these two positions effectively recreates the characteristics of a short call options position. It would usually be used if you were short on puts when expecting the underlying stock to rise in price and then had reason to believe the stock would actually fall in price.
Instead of closing your short put options position and then shorting calls, you could recreate being short on calls by short selling the underlying stock. Again, this means lower transaction costs.
Synthetic Long Put
A synthetic long put is also typically used when you were expecting the underlying security to rise, and then your expectations change and you anticipate a fall. If you had bought call options on stock that you were expecting to rise, you could simply short sell that stock. The combination of being long on calls and short on stocks is roughly the same as holding puts on the stock вЂ“ i.e. being long on puts.
When you already own calls, creating a long put position would involve selling those calls and buying puts. By holding on to the calls and shorting the stock instead, you are making fewer transactions and therefore saving costs.
Synthetic Short Put
A normal short put position is usually used when you are expecting the price of an underlying stock increase by moderate amount. The synthetic short put position would generally be used when you had previously been expecting the opposite to happen (i.e. a moderate drop in price).
If you were holding a short call position and wanted to switch to a short put position, you would have to close your existing position and then write new puts. However, you could create a synthetic short put instead and simply buy the underlying stock. A combination of owning stock and having a short call position on that stock essentially has the same potential for profit and loss as being short on puts.
Synthetic Positions – Definition
A combination of stocks and/or options that return the same payoff characteristics of another stock or option position.
Synthetic Positions – Introduction
In the early days of option trading where only call options are publicly traded, option traders who wished to speculate a downwards move while limiting upside risk need to “create” or emulate the payoff characteristics of a put option through the buying of call options and simultaneously shorting the underlying stock. The combination of call options and short stocks creates a synthetic put option, or a position with the exact characteristics of a put option. When the underlying stock drops, the call options eventually expires out of the money, losing all of its extrinsic value while the value of the short stock rises. This is exactly the same as holding put options where its extrinsic value decays away upon expiration leaving the net profit on the drop of the underlying stock.
In the above illustration, the Long Call Option + Short Stocks creates a Synthetic Put Option where the profits and losses are exactly the same as if Peter bought put options.
In fact, synthetic positions are very widely used and packaged as individual option strategies themselves. The Fiduciary Calls option trading strategy is in fact, a Synthetic Protective Put option trading strategy! Furthermore, there are many option traders who constantly creates synthetic positions through their buying of options and stocks without realizing it themselves. Having a comprehensive understanding of Synthetic Positions also allows you to prevent creating unfavorable Synthetic Positions unknowingly. Completely understanding synthetic positions is a must for every position traders.
Synthetic Positions – The Synthetic Triangle
What the Synthetic Triangle is saying is, a combination of two elements in the synthetic triangle creates a synthetic position of the third element. This synthetic triangular relationship is governed by the principle of Put Call Parity.
Synthetic Positions – Basics
There are 6 basic synthetic positions relating to combinations of put options, call options and their underlying stock in accordance to the synthetic triangle:
1. Synthetic Long Stock = Long Call + Short Put
2. Synthetic Short Stock = Short Call + Long Put
3. Synthetic Long Call = Long Stock + Long Put
4. Synthetic Short Call = Short Stock + Short Put
5. Synthetic Short Put = Short Call + Long Stock
6. Synthetic Long Put = Long Call + Short Stock
In order for the synthetic triangle relationship to work, all options used together must be of the same expiration, strike and represent the same amount of shares used in combination.
Synthetic Positions – Synthetic Long Stock
Can you create stock out of options? Yes! You can create a synthetic long stock position simply by:
Synthetic Long Stock = Long Call + Short Put
When you buy a stock, you are exposed to unlimited profits and unlimited losses while losing nothing when the stock remains stagnant. A synthetic long stock completely duplicates those characteristics. The premium gained from the short put covers the premium on the long call (thus losing nothing if the stock remains stagnant), the call option grants unlimited profits and the short put options introduced the unlimited loss.
Synthetic Positions – Synthetic Short Stock
Can you short a stock without really shorting the stock itself? Yes, you can create a synthetic short stock position by:
Synthetic Short Stock = Short Call + Long Put
When you short a stock, you are exposed to unlimited loss and unlimited profit while losing nothing when the stock remains stagnant. A synthetic short stock completely duplicates those characteristics. The premium gained from the short call covers the premium on the long put (thus losing nothing if the stock remains stagnant), the long put option grants unlimited profits and the short call options introduced the unlimited loss.
Synthetic Positions – Synthetic Long Call
If you are holding a put option or a stock, how can you transform it into a call option without selling your present positions? Simply by constructing a Synthetic Long Call by:
Synthetic Long Call = Long Stock + Long Put
If you are an experienced option trader, you would be able to immediately tell that the above equation is saying that Fiduciary Calls = Protective Puts! That’s right! That’s what this synthetic position is trying to say.
Synthetic Positions – Synthetic Short Call
If you are holding a short put option or a short stock position, how can you transform it into a short call option position without selling your present positions? Simply by constructing a Synthetic Short Call by:
Synthetic Short Call = Short Stock + Short Put
When you short a call option, you are exposed to limited profits, unlimited losses and the premium on the call options decay to your advantage. The short stock contributes the limited downside profits (all the way to $0 so technically unlimited profits to downside) and the short put options limit that profit to the premium decay of the put options while offsetting part of the loss to upside.
Synthetic Positions – Synthetic Short Put
If you are holding short call position and want to participate on an upwards move on that stock without closing your short call position, you can construct a Synthetic Short Put by:
Synthetic Short Put = Short Call + Long Stock
In a Short Put option position, you are exposed to limited profit to upside and unlimited loss potential while gaining the extrinsic value no matter what happens. Long Stocks contributes the unlimited loss potential to the synthetic position while the short call limits the potential upside profit.
Synthetic Positions – Synthetic Long Put
If you are holding long call position and want to participate on an downwards move on that stock without closing your long call position, you can construct a Synthetic Long Put by:
Synthetic Long Put = Long Call + Short Stock
Synthetic Positions – Why Use Synthetic Positions?
Why would anyone create a synthetic long call when they can simply buy call options? In fact, why would anyone use synthetic positions at all when all the instruments are now available to all option traders? Synthetic positions are useful for option traders who wish to speculate on a reverse expectation on their current holdings without closing the current holdings. Synthetic positions are also much more flexible than its equivalent instrument, making it possible to take advantage of changing conditions quicker and at a lower transaction cost.
Synthetic Positions For Reversal Of Expectations
Synthetic Positions For More Flexibility
If you had simply closed out your short call options and then wrote put options initially, you would now have to close out your short put options and buy either the underlying stock or a call option right now. Synthetic positions allowed that transition from a moderate down outlook to a moderate up outlook to a sustained up outlook very smoothly.
Synthetic Positions For Lower Transaction Cost
Write Call —> Buy Back Call —> Write Put —> Buy Back Put —> Buy Stocks
If you had used synthetic positions instead, you would have incurred only 3 transactions:
Write Call —> Buy Stocks —> Buy Back Call
Lesser transactions translates into lower transaction cost, which makes synthetic positions the most cost efficient way of trading in volatile times.
A comprehensive knowledge of synthetic positions allows an option trader to better hedge existing holdings and become more flexible in taking advantage of short term price anomalies. This is why all Market Makers need to be completely familar with synthetic positions.
Synthetic Positions – Conversions & Reversals
Conversion & Reversals are important synthetic position concepts pertaining to the closing out of synthetic positions using the actual financial instrument that they represent in order to both maintain the original position and hedge against short term price movements. Conversion & Reversals can also be used to take advantage of options arbitrage opportunities. Read more about Conversion & Reversal Arbitrage.
Synthetic Positions – Pricing
The principle of Put Call Parity governs the pricing of synthetic positions, reducing arbitrage opportunities through conversion or reversal.
Short Put Options Trading Strategy Explained
Published on Tuesday, April 17, 2020 | Modified on Wednesday, July 10, 2020
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Short Put Options Strategy
A short put is another Bullish trading strategy wherein your view is that the price of an underlying will not move below a certain level. The strategy involves entering into a single position of selling a Put Option. It has low profit potential and is exposed to unlimited risk.
A short put strategy involves selling a Put Option only. For example if you see that the shares of a Company A will not move below в‚№1000 then you sell the Put Option of that stock at в‚№1000 and receive the premium amount. The premium received will be the maximum profit you can earn from this trade. However, if the price of the underlying moves below 1000 then you will incur unlimited losses.
When to use Short Put strategy?
Short Put works well when you’re Bullish that the price of the underlying will not fall beyond a certain level.
Example 1 – Bank Nifty
** Exercise pay-off is considered 0 if it reaches above 0.
Example 2 – NIFTY OPTIONS
Suppose you are bullish on Nifty when it is at в‚№10,400. To benefit from the market scenario, you can implement Short Put option strategy by selling a Put option with a strike price of в‚№10,300 at a premium of 125 expiring on 31st July. If Nifty stays above в‚№10,300, you will be in profit and retain the premium. In case the Nifty falls, you will incur unlimited losses.
Note: Break Even Point is 10,175. The maximum profit earn cannot be greater than в‚№9,375 premium paid.
Market View – Bullish
When you are expecting the price or volatility of the underlying to increase marginally.
A short put strategy involves selling a Put Option only. So if you see that the shares of a Company A will not move below a 1000 then you sell the Put Option of that stock at 1000 and receive the premium amount. The premium received will be the maximum profit you can earn from this deal. However, if the price of the underlying moves below 1000 than you will incur losses.
Strike Price – Premium
Risk Profile of Short Put
There is no limit to losses incurred in the trade. The risk is when the price of the underlying falls, and the Put is exercised. You are then obliged to buy the underlying at the strike price.
Reward Profile of Short Put
The profit is limited to premium received in your account when you sell the Put Option.
Max Profit Scenario of Short Put
Underlying doesn’t go down and options remain exercised.
Max Loss Scenario of Short Put
Underlying goes down and options remain exercised.
Advantage of Short Put
It allows you benefit from time decay. And earn income in a rising or range bound market scenario.
Disadvantage of Short Put
It is a high risk strategy and may cause huge losses if the price of the underlying falls steeply.
How to exit?
Bull Put Spread, Covered Call, Short Straddle
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Short put: sellers of put options hope the stock price to go up or stay around current levels. If the asset price decreases, options sellers are obliged to buy shares at a predetermined price (strike). A seller of a put option receives a premium, that is, the profit potential is limited and known in advance, while risks are conditionally unlimited.
Selling put options is often interesting when you want to buy stocks at a more attractive price and when the market is about to fall slightly or consolidate. Large investors often use the strategy during periods of uncertainty when the market is overheated and a seller of the put option doesn’t mind buying the underlying asset but believes that the market may decline, or wants to make additional profits from the increased implied volatility.
In this case, a seller receives a premium, but runs the risk of losing a position if the underlying asset price actively rises. The worst scenario for the put option seller is a sharp fall in prices below the strike, and the maximum profit is limited to the premium and can be received if the underlying asset price is higher than the strike price of the put option sold.
Suppose, we sell the put option for $20 when the strike price is $100 and then the asset price starts falling and reaches the price mark of $81. The option is in-the-money and our position is losing money but the break-even point hasn’t been reached yet, it’s around $80 that’s why there’s nothing to worry about.
After that, the market starts rising and it’s around $95 on the expiration date. As a result, the option is $5 in-the-money, and the financial result will be equal to: $20 (premium) – $5 (intrinsic value of the option) = $15*100 = $1500.
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