Position Management: Demystifying Synthetics

Position Management: Demystifying Synthetics

What is a synthetic Futures, Options or Stock Position?

A “synthetic” position can be used to obtain the risk profile of a desired position, while using a combination of underlying stock/etf/future and/or its options to do so. Stick with me for a moment – we’ll be using $AAPL  as examples below, but the same may be applied to any other optionable instrument. For example, a trader can synthetically purchase 100 shares of $AAPL stock, currently trading at $180, by purchasing the $180-strike call and simultaneously selling the $180 strike put. Here is the proof: On the chart below we can see the risk profile of being long 100 shares of AAPL at $180. Now here is the SAME exact risk profile, using options: Notice that the +100 $AAPL shares were unchecked, and instead I selected a long $180 call, and a short$ 180 put [Expiring on 1/20/2022]. Also notice that this position can be put on for a net credit, too. But more importantly, notice that the risk curve, which in this case is a straight rising line due to the positive 100 deltas on $AAPL we get exposure to, is IDENTICAL to being long 100 shares of $AAPL! For now, I hope this example is enough to get past the initial cryptic description. The important aspect is that both positions are identical from a risk perspective. There may be several ways to conceptualize “synthetic” positions and how they may help you as a trader, by far the one I've found easiest to not only digest but remember over the years is what I'm about to share with you in this article. To start simple, let's first establish some fundamental concepts about the possible ways one can trade the current equity/futures market. For the sake of this article, let’s say there are 6 possible ways we can express ourselves in a trade. This encompasses the main retail trading vehicles: Stock/ETFs/Futures, and Options on each of them. Note that in order for synthetics to work, we must be using an optionable underlying. Without an options market, it’s not possible to create the synthetic positions this article will discuss. However, this shouldn't be an issue for us since most of the instruments we trade have both markets active.

The 6 possible positions and how I came to memorize them

  1. Long stock
  2. Long call option
  3. Short put option
  4. Short stock
  5. Long put option
  6. Short call option
I group them this way in my head. 3 ways to buy deltas and 3 ways to sell deltas (or buy negative deltas.) In the playground for creativity that the options market brings to the table, let us express any of the 6 positions mentioned above as a combination of either 2 options, or 1 option and 1 stock/future. We’ve already covered the first of 6, long stock/etf/future.  How about shorting stock? Here’s the risk profile of being short 100 shares of $AAPL.

So, how could we do this with options?

Easy – do the opposite of what we did for getting long. Simply reverse the trade – ie, buy the put, and sell the call. Let’s move onto creating synthetic options! Here’s the risk profile of a long ATM call on $AAPL: As you can see, the single long call option gives us capped downside risks, and uncapped upside gain potential. Yet here is the exact same trade, expressed a bit differently: What did I do? Long call = long stock + long put, as you can see below.

How about some short options?

Here is the risk profile of a short ATM call on $AAPL – the 180 strike we’ve been using during these examples. Now how on earth can one pull this off?  Short call = short stock + short put You know those so-called “trading strategies” that use “selling puts for income” as means of collecting a premium on short stock? That strategy risk wise is just a naked short call. Its risk profile is identical…so why complicate the “strategy” so much? Perhaps it's not such a good strategy after all…? =) Last but not least, short puts: Some folks may wish to get short put exposure to some names. How else could this be accomplished? This one may come as a surprise to many…as what I’m about to show you is one of the more common retail strategies.

The Covered Call

Yep, buying stock and selling calls against it is synthetically equivalent to being short a naked put. The mnemonics that I use to keep this info in memory.
  • Long stock = long call + short put [uncapped upside gains, max loss if stock goes to $0 or negative]
  • Short stock = short call + long put [uncapped upside loss, max gain if stock goes to $0 or negative]
  • Long call option = long stock + long put [capped risk, uncapped upside gain]
  • Short call option = short stock + short put [“selling puts for income” – uncapped upside risk, capped gain from little volatility]
  • Long put option = short stock + long call [capped risk, uncapped downside gain]
  • Short put option = long stock + short call [“the covered call is synthetically equivalent to a naked short put option”, uncapped downside risk, capped gain from little volatility]
When does this come in useful? One of several is during times of stress –locked limit markets – most of the time the options market remains open for some time even though the primary market is closed. One can use knowledge of synthetics to get out of a terrible situation, or partake in a wonderful opportunity! Such as buying/selling a stock synthetically in the options market, even though it’s limit is locked in its primary market. This info is quite useful for risk management as well, so definitely one to keep sharp in the toolbox. Hope this has been useful! [DISPLAY_ULTIMATE_PLUS]