Synthetic Positions

In our last discussion on the Ratio Spread Strategy, we explored how selling multiple options against a single purchased option can maximize returns in moderate market movements. Today, we are going to look at Synthetic Positions, a creative and powerful way to replicate the payoff of actual stock positions using options. This is an ideal strategy for traders who aim to hedge, speculate, or reduce capital requirements with the same risk-reward profile as holding the underlying asset.

What are Synthetic Positions?

Synthetic Positions: This involves combining options and sometimes the underlying asset to mimic the pay-off of some other trading position. The word "synthetic" here means that, with options, one could synthetically replicate the behaviour of a real stock or options position without actually holding it.

For example:

• The Synthetic Long Stock is constructed by buying a call and selling a put of the same underlying and strike price.
  
• A Synthetic Short Stock combines a long put and a short call at the same strike price.
  

These strategies are particularly useful for traders who want to replicate a stock position without tying up significant capital.

Why Traders Choose It

The Indian Derivatives Market provides great avenues for Synthetic Positions, considering the heavy volumes of trading in indices such as Nifty and Bank Nifty, among other individual stocks. Here is why Indian traders find this approach appealing:

1. Capital Efficiency: Much less margin is required compared to buying or selling short the actual stock.
   

2. Versatility: Synthetic positions can be utilized for speculation, hedging, or arbitrage.
   

3. Flexibility: One can buy or sell positions in a very short time without having to physically sell or buy stock.
   

Synthetic Positions - Types

1. Synthetic Long Stock

• How to Do It: Buy a long call and buy a short put at the same strike price.
  
• When to Use: When you are bullish on the stock but you want to save capital instead of buying the actual stock.
  

Example: Suppose Reliance is at ₹2,500:

• Buy the Reliance 2,500 Call for ₹100.
  
• Sell a Reliance 2,500 Put for ₹ 80.
  
• Net Debit is: ₹20 (₹100 - ₹80).
  

This creates a payoff similar to owning the stock outright, but with significantly less margin.

2. Synthetic Short Stock

• How it works: This spread combines a long put and a short call at the same strike price.
  
• When to Use: Use when bearish on the stock yet wish not to short due to higher margin requirements.
  

Example: For the same reliance stock:

• Buy Reliance 2,500 Put for ₹ 100.
  
• Sell a Reliance 2,500 Call for ₹ 80.
  
• The Net Debit: ₹20 ₹(100 - ₹80).
  

This reflects the payoff for short selling the stock.

When to Use Synthetic Positions?

Synthetic Positions are best suited for the following:

1. Hedging: It protects a long or short stock position against adverse price movements.
   

2. Speculation: Take directional bets in Stocks/Indices with minimal capital.
   

3. Arbitrage: The opportunity to exploit mispricing between synthetic and actual positions to achieve risk-free profits.
   

Synthetic Position Benefits

1. Capital Efficiency: Release capital for other trades; avoid direct buying of stocks or selling them short.
   

2. Risk Management: Hedge current positions without actually adjusting your portfolio.
   

3. Profit Potential: The same payoff as real positions with less margin.
   

Risks to Watch

While Synthetic Positions replicate the payoff of actual stock positions, there are some unique risks:

1. Assignment Risk: Short options in the strategy can be exercised unexpectedly and hence lead to sudden stock positions.
   

2. Margin Requirements: While lower than outright stock trading, margin calls are possible in the event of sharp market moves.
   

3. Volatility Sensitivity: An implied volatility level is usually set for option prices, which impacts the cost-effectiveness of this strategy.
   

Conclusion

The Synthetic Positions Strategy is indeed a very innovative and effective strategy that helps traders replicate real underlying stock positions efficiently with optimization of capital utilization. Whatever your objective may be whether it is speculation, hedging, or risk management, this approach provides unparalleled flexibility in options markets. If this chapter has set you thinking, stay tuned for our next discussion: Option Greeks and Their Applications. To master options trading through the dynamic new markets in India, one has to understand Greeks such as Delta, Theta, and Vega.