Synthetic Positions

A synthetic position is the combination of one or more options and out-rights to simulate an equivalent position. Options allow the trader to simulate various outright and option positions and therefore allow more possibilities in trading.

Synthetic Long or Short Positions

A synthetic long or short position may be created using options of the same strike and expiration. For example, the simultaneous purchase of a September 100 call for $5 and sale of a September 100 put for $5 will create a synthetic long position. A synthetic short position can be created by the purchase of the October 100 put and sale of the October 100 call. These positions exhibit the same profit and loss possibilities as being long or short the future.

Synthetic Calls and Puts

Buying a future and selling a call is known as covered call writing. For example, the profit and loss potential in the present and at expiration of buying the future and selling the November 100 call. The reward is limited by the sale of the call, but the risk may be much larger due to the long future position. What position does this strategy simulate? It is exactly the same as selling a put.

The supposedly conservative covered call writer is in fact selling puts. The logic for using this strategy follows. The call protected the owner of the stock or future from a slight drop in price. If the market went up, the writer received the call premium and the stock or future covered the short call. This type of strategy was widely used before the great stock market crash of 1987 when "conservative" investors wrote covered calls. However, when the stock market collapsed, the "conservative" investors found out the hard way that they were actually selling puts and lost substantial sums of money.

To this day there are people who swear they would not sell options naked because of the obvious risk, but are quite comfortable writing covered calls. This is perhaps one of the best examples of why options should be thoroughly understood before using them.

A synthetic short call position may be established by selling a put and selling the future short. The profit and loss potential is identical to selling a naked call.

Buying a future and buying a put is an example of buying a synthetic call. The purchase of the December 100 put for $3 and A conversion is the combination of a long future position and short synthetic position. The person is long the underlying future, long the put, and short the call. A reversal is the opposite position which is short the future, long the call, and short the put.

These types of trades are a form of arbitrage and are usually done by market makers or other participants with low commissions and margins. The trades are usually done for small profits to take advantage of minor price discrepancies in the market. For example, assume the future is trading at 100 and the January 100 call is $5, and the January 100 put is $4. The market maker would buy the future at 100, buy the put for $4, and sell the call for $5, and receive $1. The synthetic short position is equivalent to being short at 101 due to the $1 received from buying the put and selling the call. Since the future is purchased at 100, a profit of $1 is made through the arbitrage.