Introduction To Synthetic positions

Synthetic comes from the word synthesis. The term synthetic brings to mind a definition : To mix, combine and fabricate to form a unique whole. Hence, synthetic positions employ stock and options in a multitude of ways. While synthetic positions are not well received with option traders, It is a very important topic as it helps a trader morph option positions while simultaneously lowering costs to increase profits due to the put call skew.

  1. Mimic real positions – The most obvious value of synthetic positions to an options trader is to imitate the payoff profile of certain options strategies. It is possible to combine several types of securities to create a position which is identical to another, matching the overall risk and reward scenarios of a real position.
  2. Create positions which are less affected by option greeks – The second value of synthetic trades to option traders is the morphing of a trade to one which will be less affected by the option greeks. For example, buying options outright can be very profitable operation. Using a call option, a trader can capture enormous sums of profit if there is a significant upswing in price. However, buying a call option will subject a trader to loss in time value, volatility and the greeks. Considering that approximately three-quarters of all options which are held to expiry expire worthless, an options trader may choose to use synthetic positions instead and hence, avoid the being subjected to declining time value and the option greeks.
  3. Lower margin requirements for synthetic positions – In fact, synthetic positions may be even cheaper than buying options outright. Most brokerage firms also declare synthetic positions to be less risky than buying options outright. This is evident in the reduced margin requirements of synthetic positions.

In the next few articles, we will discuss: