Synthetic Underlying Explained

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Synthetic underlying position

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Please help improve this article by adding citations to reliable sources. Unsourced material may be challenged and removed. (December 2009)

In finance, a synthetic underlying position is one that synthetically duplicates the payoff of a long underlying position with a long call and short put at the same strike and expiration. For example, a position which is long a 60-strike call and short a 60-strike put will always result in purchasing the underlying for 60 at exercise or expiration. If the underlying is above 60, the call is in the money and will be exercised; if the underlying is below 60 then the short put position will be assigned, resulting in a (forced) purchase of the underlying at 60.

One advantage of a synthetic position over buying or shorting the underlying stock is that it allows tweaking. For example, in the above example, one could instead long a 60-strike call and short a 55-strike put, if the stock is trading somewhere in between the two strike prices. This way, even if the stock falls a little, the position does not lose any money as long as the stock price stays above 55 at options expiration.

A synthetic underlying position has the same delta as the non-synthetic (real) underlying position.

When the underlying is stock, a synthetic underlying position is sometimes called synthetic stock.

Synthetic Put

What Is a Synthetic Put?

A synthetic put is an options strategy that combines a short stock position with a long call option on that same stock to mimic a long put option. It is also called a synthetic long put. Essentially, an investor who has a short position in a stock purchases an at-the-money call option on that same stock. This action is taken to protect against appreciation in the stock’s price. A synthetic put is also known as a married call or protective call.

Key Takeaways

  • A synthetic put is an options strategy that combines a short stock position with a long call option on that same stock to mimic a long put option.
  • Synthetic put is a strategy that investors can utilize when they have a bearish bet on a stock and are concerned about potential near-term strength in that stock.
  • A synthetic put’s goal is to profit from the anticipated decline in the underlying stock’s price, which is why it is often called a synthetic long put.

Understanding Synthetic Puts

The synthetic put is a strategy that investors can utilize when they have a bearish bet on a stock and are concerned about potential near-term strength in that stock. It is similar to an insurance policy except that the investor wants the price of the underlying stock to fall, not rise. The strategy combines the short sale of a security with a long-call position on the same security.

A synthetic put mitigates the risk that the underlying price will increase. It does not, however, deal with other dangers, which may leave the investor exposed. Because it involves a short position in the underlying stock, it carries with it all the associated risks of an adverse, or up-market, move. Risks include fees, margin interest, and the possibility of having to pay dividends to the investor from whom the shares were borrowed to sell short.

Institutional investors can use synthetic puts to disguise their trading bias, be it bullish or bearish, on specific securities. However, for most investors, synthetic puts are best suited for use as an insurance policy. An increase in volatility would be beneficial to this strategy while time decay would impact it negatively.

Both a simple short position and a synthetic put have their maximum profit if the stock’s value falls to zero. However, any benefit from the synthetic put must be reduced by the price, or premium, which the investor paid for the call option.

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The synthetic put strategy can place a practical ceiling, or cap, on the price of the stock for a ‘fee’, the options premium. The cap limits any upside risk for the investor. The risk is limited to the difference between the price at which the underlying stock was shorted and the option’s strike price and any commissions. Put another way, at the time of the purchase of the option, if the price at which the investor shorted the stock was equal to the strike price, the loss for the strategy would be the premiums paid for the option.

  • Maximum Gain = Short sale price – Lowest stock price (ZERO) – Premiums
  • Maximum Loss = Short sale price – Long Call Strike price – Premiums
  • Breakeven Point = Short sale price – Premiums

When to Use a Synthetic Put

Rather than a profit-making strategy, a synthetic put is a capital-preserving strategy. Indeed, the cost of the call portion of the approach becomes a built-in cost. The option’s price reduces the profitability of the method, assuming the underlying stock moves in the desired direction lower lower. Therefore, investors should use a synthetic put as an insurance policy against near-term strength in an otherwise bearish stock, or as a protection against an unforeseen price explosion higher.

Newer investors may benefit from knowing that their losses in the stock market are limited. This safety net can give them confidence as they learn more about different investing strategies. Of course, any protection will come at a cost, which includes the price of the option, commissions, and possibly other fees.

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