A synthetic position is a replica of a stock or options position. You can set it up as a standalone strategy or it can be the progress of an existing position.
For example, you sold a put but your strike was breached and you got assigned shares. Now you want to get rid of them and sold a call option.
We can argue that the covered call you have now is a synthetic short put. It has the same payoff as a short put but more importantly you never meant to set it up in first place.
Let’s start with a basic synthetic position.
Synthetic stock position
This strategy has two variations: synthetic long stock and synthetic short stock. You set it up by using the at the money (ATM) call and put options.
Fair warning, synthetic stock is a risky trade, long or short.
Synthetic long stock
You are determined the stock is going up so you can just buy it or buy a call option. However, you’d need to commit significant capital. It may be less for the option but the ATM 54 day call in SPY currently costs $10.20.
If you are convinced SPY is going up you can buy the $350 call for $10.20 and sell the $350 put for $12. You’ll get a nice $180 premium upfront and if you’re right and SPY goes up to $365 next week, all things being equal, you’ll realise an overall profit of $1,000.
On top of that you only commit around $9,000 worth of capital instead of $35,000.
However, if SPY goes down you’ll make a loss of $1,000. The only advantage compared to stock is that you have the initial $180 to recoup some of the loss.
This strategy is cost effective but the losses can be substantial. Furthermore, you are trading options which will expire eventually. The worst case scenario is to experience a large loss and to see the stock recover after expiration.
Synthetic short stock
It’s the reverse of synthetic long stock. You sell the ATM call and buy the ATM put.
If we use the $350 SPY strike again you’ll end up paying $1.80 for the strategy. Therefore, you have to take into account any debit paid or credit received.
You have a short ATM short call leg so the risk is substantial but can’t be higher than short selling stock. Here’s an example:
Poor man’s covered call
We can call it a synthetic covered call, a diagonal spread or pick something else if you want. All there is to it are two call options.
You buy a long duration, usually a few months, in the money (ITM) call and you sell a shorter duration, weekly for example, out of the money (OTM) or ATM call depending on your requirements.
The first important issue is whether the long call will remain in the money. Secondly, it is optimal for the extrinsic value of the short call to be equal or higher to the one of the long call. This may be difficult to achieve if you are selling weeklies so you have to set your goals upfront.
You don’t want to pay more than 70-75% of the width of the strikes between the long and the short call.
Ideally, you’ll be directionally correct, your short strike will be breached and you’ll collect the width of the strikes within one expiration cycle. Otherwise you’ll keep selling short duration calls.
If the stock starts to lose value you can roll the short call down to collect more premium. The worst case scenario is if the stock crashes and doesn’t recover until the expiration of the long call leg.
Poor man’s covered put
This is quite similar to the above only this time you buy a longer duration in money put and sell a shorter duration out of the money put. You can think about it like a diagonal spread.
It follows the same logic as the poor man’s covered call only that you are trading the put side. This time the worst case scenario is when the long put ends up out of the money due to an explosive up-move.
Synthetic long put
As the tittle suggests you aim to replicate the payoff of a long put. The set-up is simple: short sell 100 shares and buy a call.
Why not just buy a put instead? It seems like a sensible question. You may incurr borrow fees for the stock, it will block margin and you have to pay for the call anyway.
The most common scenario is that you were already short the shares and decided to limit the risk by buying the call.
For a European style put we can buy a call option, short the stock and buy a discount bond. The latter refers to a bond trading below its face value. This method takes advantage of put-call parity.
I will not cover the synthetic short put because it is a covered call and you likely know how that works.
Synthetic long call
The payoff is exactly the same as a long call but the intent of the position is different.
If you buy a call you have a strong conviction that the share price will increase. Then why would you buy a put and 100 shares to recreate it synthetically, you’d just buy a call or the shares.
Clearly you are worried about downside risk and decided to buy some insurance. This is perfectly fine, I just wanted to point out that the decision making process behind the two positions is different.
The other distinction is that you commit capital to the stock. It can be a good or a bad thing depending on your requirements.
The synthetic equivalent of a short call is the covered put.
A more accurate way to construct a synthetic long call, applicable to European style options, is to take advantage of put-call parity.
We’ll use the example above to create a 60 strike call. All you have to do is buy the put and stock as in the example and then borrow the present value of the strike at the risk free rate. That’s close to 0 in most places so we can go with $6,000 or $5,985 for 12 months.
What if the bank won’t lend at 0.25%? You can short sell an appropriate bond. Obviously, this is not feasible for retail traders but this article is largely explanatory so I felt the need to mention it.
If you add a second long put to a synthetic long call you’d end up with a synthetic long straddle. Therefore, if you have a covered call and sell one more call you have a synthetic short straddle.
When to use a synthetic position
The only popular synthetic position is the poor man’s covered call. It’s easy, intuitive and it gives you access to covered calls at reduced cost. Just make sure you don’t overpay for it.
I don’t think that trading synthetic stock due to lack of capital is a good idea. It is cheap to set up but the losses are just as big. Therefore, if you can’t afford the stock you may want to avoid replicating it.
The rest of the positions are somewhat more capital intensive than their organic counterparts. Consequently, they can serve a purpose if you already have the stock position required for the set-up.