In Investing, what is Synthetic Stock?
Synthetic stock is an asset created from a combination of other forms of assets. A synthetic stock position is a derivative trade designed to simulate a cash or spot position. The equity options market is typically used to create a synthetic stock position, the most common form of which is constructed using common exchange traded options. Long and short synthetic stock positions can be created using various combinations of puts and calls. These positions duplicate the profit and loss scenarios of stock ownership.
The long synthetic stock position is created by buying a call and selling a put. Both the call and the put must have the same expiration and strike price. At the money (ATM) options should be used with a delta very close to plus or minus 0.50, the final position delta being zero. The theoretical cost of this trade is zero, but the broker will retain enough funds to cover the short option position being exercised.
Short synthetic positions are created by buying a put and selling a call. The same rules apply as to expiration date and strike price. Delta 0.50 puts and calls are always ATM options, meaning the strike price is very close to the actual cash value of the underlying stock. The actual cost of this trade will be a small debit or credit to the account, but that does not include broker commissions. The broker will always put enough funds on hold to cover the risk of the short option being exercised.
Option contracts are sized in lots of 100 shares of stock, so one options contract equals 100 shares of the underlying stock. When opening a long or short synthetic stock position, the investor will control 100 shares of stock per contract. The investor will theoretically realize a profit or loss identical to a long or short cash position in the stock.
The advantage to synthetic positions is the ability to capture profits with a smaller initial investment than buying the stock outright. The investor is also liable for the losses if the stock takes an adverse price change. Another benefit of the short synthetic position is the ability to short sell a stock regardless of short sell rules. The disadvantage of synthetic positions is the expiration of the contract.
Synthetic stock positions can be used as part of a complex trading strategy. The investor who owns shares in a dividend paying stock might be expecting a general decline in the market. Instead of selling the income producing portfolio, the trader may decide to create a hedge by opening a synthetic position. This would enable the trader to take advantage of the ongoing dividend payments while avoiding capital losses due to the devaluation of the stock.
Many other creative option trades can be based on the synthetic stock position. The investor could, at any time, add another option trade to the synthetic position if market conditions change. The investor could also close out one leg of the trade creating a simple option position. Option trading provides the investor the ability to create unique and interesting positions in the stock market.
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