How to create a Synthetic Put
The term synthetic is often used to describe a manmade object designed to imitate or replicate some other object. Futures and options traders can do the same thing by creating a trading vehicle through a combination of futures and options to replicate another trading instrument. You may be asking yourself; why you would go through the hassle of mimicking an instrument instead of simply trading the original? The answer is simple, as the creator of the vehicle, we can customize it to better suit our needs as well as design it to better take advantage of the underlying market.
Through the creation of a synthetic position, you can actually decrease your delta as well as, in my opinion, increase the odds of success. Let's take a look at an example of a long synthetic put option.
Synthetic Long Put Option
Sell a Futures Contract
Buy an at-the-money Call Option
When to Use Synthetic Puts
• When you are very bearish, but want limited risk
• The more bearish you are the further from the futures (higher strike price) you can buy, although a true synthetic put involves an at the money call option
• This position is sometimes used instead of a straight long put due to its flexibility
• Like the long put this position gives you substantial leverage with unlimited profit potential and limited risk
Profit Profile of a Synthetic Put Strategy
• Profit potential is theoretically unlimited
• At expiration the break-even is equal to the short futures entry price minus the premium paid
• Each point market goes below the break-even profit increases by a point
The Risk in Trading Synthetic Puts
• Your loss limited to the difference between the futures entry prices and call strike price plus the premium paid for the option
• Your maximum loss occurs if the market is above the option strike price at expiration
Example of a Synthetic Put Option in the Futures Market:
A commodity trader looking to profit from a decrease in prices but isn't confident enough in the speculation to sell a futures contract, or even construct an aggressive option spread, might look to a synthetic put.
A synthetic put option strategy has nearly identical risk and reward potential as an outright put option, making it a potentially expensive proposition. However, if the volatility and premium are right it can be a great way to sell a futures contract, while retaining a piece of mind, and the ability to easily adjust the position because the purchased call option provides an absolute hedge of risk above the strike price.
A trader that is bearish on the U.S. dollar might opt to sell a dollar index futures contract near 96.60 in hopes of weakness. Should the trader prefer to have limited risk, and be willing to pay an “insurance” premium for protection, might purchase a 97.00 call option for 60 ticks, or $600, because each tick in the dollar index futures and options is worth $10 to a commodity trader.
Click on image to enlarge.
With a synthetic put option in place, the trader can sleep at night knowing the worst case scenario is a loss equivalent to the distance between the future entry price and the strike price of the call option, in this case $400 ((97.00-96.60) x $10), plus the cost of the long option purchased to insure the trade, or $600 (60 x $10).
The payout of this trade at expiration may be identical to a long put option, but the flexibility provided to the trader is unmatched. Unlike a long put, a synthetic long put can be pulled apart prior to expiration in an attempt to capitalize on market moves. Please note that doing so greatly alters the profit and loss diagram.
An example of an adjustment may be to take a profit on the short futures contract and hold the long call in hopes of a subsequent market rally and the possibility of being profitable on both the futures position and the long option. Or, should the trade go terribly wrong from the beginning a trader may look to take a profit on the long call and hold the short futures in hopes of a reversal. Doing so would eliminate the insurance of the long call and leave the trader open for unlimited risk on the upside, but may be justified if the circumstances are right.
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