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Synthetic Options Explained
One of the interesting features about options is that there is a relationship between calls, puts, and the underlying stock. And because of that relationship, some option positions are synthetic to others. The prices of put and call options have an identity relationship through the concept of put-call parity.
Some option combinations are easier, or less costly to trade than others. Which means less slippage and less commissions.
Here are few examples of synthetic options positions.
Synthetic Long Stock
Among the many options strategies, one of the most interesting is synthetic long stock . This combines a long call and a short put opened at the same strike and expiration. The name “synthetic” is derived from the fact that the two positions change in value dollar for dollar with changes in 100 shares of stock.
|Synthetic Long Stock Construction|
This is an unlimited profit, limited risk options trading strategy that is taken when the options trader is bullish on the underlying security but seeks a low cost alternative to purchasing the stock outright.
Synthetic Short Stock
The synthetic long stock is a low-risk, highly leverage strategy. But for synthetic short stock, the risk profile is completely different. For the synthetic long, the combination consists of a long call and a short put, at the same strike, and at the same expiration.Reversing the positions to short call and long put creates a synthetic short stock, and completely changes the risk.
|Synthetic Short Stock Construction|
This is a limited profit, unlimited risk options trading strategy that is taken when the options trader is bearish on the underlying security but seeks an alternative to short selling the stock.
Synthetic Long Call
A synthetic call, or synthetic long call, is an options strategy in which an investor, holding a long position in a stock, purchases an at-the-money put option on the same stock to protect against depreciation in the stock’s price. It is similar to an insurance policy.
|Synthetic Long Call Construction|
This is an unlimited profit, limited risk options trading strategy. A synthetic call is also known as a married put or protective put. The synthetic call is a bullish strategy used when the investor is concerned about potential near-term uncertainties in the stock. By owning the stock with a protective put option , the investor still receives the benefits of stock ownership, such as receiving dividends and holding the right to vote. In contrast, just owning a call option , while equally as bullish as owning the stock, does not bestow the same benefits of stock ownership.
Synthetic Long Put
By combining a long call option and a short stock position, the investor simulates a long put position. A synthetic put is also known as a married call or protective call.
|Synthetic Long Put Construction|
This is a limited profit, limited risk options trading strategy. The synthetic put is a strategy, used when the investor has a bearish bet and is concerned about potential near-term strength in the underlying 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.
Other Equivalent Positions
The basic equation that describes an underlying and its options is: Owning one call option and selling one put option (with the same strike price and expiration date) is equivalent to owning 100 shares of stock. Thus,
S = C – P; where S = stock; C = call; P = put
There are some other options positions that can be considered equivalent. For example, take a look at a covered call position (long stock and short one call), or S-C.
From the equation above, S –C = -P. In other words, if you own stock and sell one call option (covered call writing) then your position is equivalent to being short one put option with the same strike and expiration. That position is naked short the put. Amazingly some brokers don’t allow all clients to sell naked puts, but they allow all to write covered calls. But as we can see, writing a covered call is equivalent to selling a naked put.
Synthetic positions can be used to change one position into another when your outlook changes. Options offer enormous flexibility in positioning. Synthetics can offer an alternative plan B, require less capital, eliminate the need to borrow the stock if selling it short etc. It is essential to understand synthetic options in order to fully utilize the flexibility of options.
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Reduce your Transaction Cost using Synthetic Long/Short Future
November 17, 2020 by Rajandran
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If you are a professional future trader in the markets then transaction cost plays a major role while trading. Lower the transaction cost translates to better returns and also reduces the risk to greater extent in the long run. By constructing a Synthetic Futures (Long/Short) we can reduce the total transaction cost by two-third of the actual instead of trading the futures.
Synthetic Longs/Short future is nothing but artificially replicate a long/short futures pay off using same expiry options. Synthetic Long Futures is constructed by using Buying 1 At the money call and Selling 1 At the money put of same strike price . Similarly Synthetic Short Futures is constructed by using Buying 1 At the money put and Selling 1 At the money call of same strike price
Synthetic Long Futures = Buy 1 ATM Call + Sell 1 ATM Put
Synthetic Short Futures = Buy 1 ATM Put + Sell 1 ATM Call
Lets Assume that Mr Ravi is a professional trader on an average he trades 10 lots of nifty futures in a day and he trades with a discount broking firm at Rs20/Order. If Nifty is trading at 8100 then his average transaction cost (including Brokerage + Govt Charges) comes around Rs957/- per buy and sell transaction. Total Transaction Cost is shown below.
Long Futures – Transaction cost
Now lets construct a Synthetic Long Futures using 8200CE ATM Call Longs and Shorting 8200PE ATM Put Short (November Series) as shown below
Payoff Graph for Synthetic Long Futures is shown below.
In case of Synthetic Futures both the leg transaction cost come down to Rs 315/-. Ravi would have saved Rs642/ instead of trading futures which directly translates to two-third of brokerage savings. In a year if you assume there are 250 trading sessions then probably he would save 642 x 250 = Rs1,60,500/- annually (approx figures) which makes a huge difference in his trading system returns and thereby improved ROI.
Synthetic Futures – Transaction cost
Note : Synthetic Future is recommended to be used only for Nifty/Bank Nifty Trading because of high liquidity and lower impact cost
Futures Trading Explained – Futures vs Options vs Stocks…
Futures are one of the, if not even THE most traded and oldest derivative in the markets. They are standardized, extremely liquid and can be traded on almost any underlying asset or security. Nevertheless, many people either have no idea what futures are or can’t tell the difference between futures and other derivatives like options or forwards. In this article I will try to clarify what futures are, how futures differ from other derivatives and when they are a good investment vehicle.
What Are Futures
Futures are standardized, exchange traded derivatives that are very popular. In other words, futures aren’t fully customizable as all futures follow the same basic guidelines and futures are traded on exchanges meaning that they aren’t over-the-counter (OTC) products that are made from your broker. More on that later.
Other derivatives would be options, forwards, CFDs and many more. But there are some differences between futures and forwards/CFDs. These are not exchange traded because they are OTC products. Most of these derivatives work quite similar and therefore it is even more important to learn the small differences.
How Do Futures Work – Futures Trading Explained
Basically, Futures are an agreement with a second party to buy or sell an asset for a certain price at a future date. The underlying really can be anything, but typically this is some sort of commodity or similar asset. The original idea behind futures is to get rid of unwanted price volatility. Big firms and corporations that are dependent on certain commodities, use futures to guarantee that they can buy or sell these commodities for a certain price on a future date. For example a big oil firm would sell futures to lock in the oil price, meaning if the oil price falls until the expiration date they still can sell their oil at this price. The other side of this trade could be gas stations that buy futures to guarantee the oil for the agreed upon price. This is good for both because with this price both sides can profit from their oil. Without a futures contract, one side may profit from an incline in oil prices and the other side would lose.
Additionally, futures can of course also be used for pure speculation and very many futures are used for that purpose. In this sense futures speculation is quite similar to options speculation. Basically, you buy futures if you think that the price will rise and you sell futures when you think the price will fall. But there are some more things to futures which I want to discuss now:
The gains and/or losses made from your futures positions are debited/credited to your account after each trading day. So if you enter a long futures position on an underlying that is trading at 100$ and the price of the underlying moves up one Dollar within one day, you will be credited one Dollar (without leverage factored in). Therefore, you need enough capital in your account to handle the price fluctuations. Otherwise, you can’t open a futures position. If a price fluctuates too much and your account can’t handle that, you will receive a margin call requiring you to deposit more money or your position will be closed. Most brokers only allow you to trade futures in ‘bigger’ accounts and margin accounts.
As you can see the payoff profile of long and short futures looks quite similar to the payoff of long and short stock or forward positions. The more the price of the underlying moves in the correct direction, the bigger the profit becomes. The further it moves in the other direction, the bigger the loss becomes. Your P/L at expiration would be the difference between the underlying’s price at entry and on the expiration date. So futures are both undefined risk and undefined profit strategies. I will now move on to the actual differences between all these investment products (futures, options, stocks, forwards…):
Let’s begin with the more general bigger differences. One big difference between the futures market and the stock/option market are the market hours. The futures market isn’t settled in one central location. The market is open 24 hours a day, five days a week. It opens 5pm. EST on Sunday and closes 4pm. EST Friday.
Furthermore, the difference between futures and many other derivatives is that they are settled physically. This means that the actual physical underlying will be delivered at expiration. For example, if you buy futures on oil and don’t close the position before expiration, a truck full with barrels of oil will come to your house and deliver physical barrels of oil into your driveway. So if you aren’t an institution that actually wants these commodities, it is extremely important that you close any futures positions before the expiration date. It is never nice to have to get rid of huge amounts of commodities like oil.
What Is The Difference Between Futures And Options
Even though options and futures seem very similar, they do have some essential differences that are important to know. One main difference being that an option buyer has the right and not the obligation to exercise his option. This means that the buyer can choose to buy or sell the underlying asset at the predetermined price. This is different with futures. In futures, both parties (buyer and seller) have the obligation to buy/sell the underlying asset at the predetermined price on the expiration date. The next big difference is that options require a premium to open. So option buyers pay a premium to open their position and the seller receives one. Futures don’t require any premium to open.
Additionally, futures mostly have much larger underlying sizes. One standard option contract controls 100 shares of the underlying asset, whereas futures contracts often control much more.
The last important difference is the payoff profile of these two derivatives. Options are either defined risk (long options) or defined profit (short options). Futures are both undefined risk and undefined profit, just like stocks. This means that there is no limit for your maximum gain/loss.
Future Contracts vs Forward Contracts
Both futures and forwards don’t require a premium to open. But as the gain or loss made from futures is credited or debited to your account daily, you usually need to have enough free margin. So forwards can be opened even if you have no capital/margin to allocate (this may vary from broker to broker). Otherwise, these two derivatives work very similar, have the same payoff and only few differences. But one more difference is that forwards are Over-The-Counter (OTC) derivatives meaning that they usually aren’t standardized and exchange traded. Therefore, liquidity the forwards market is often quite limited and it can be hard to close positions before expiration. On the other hand, forwards often are more customizable in regards to expiration date. Forwards are only seen and used rather rarely in the retail trading market.
Stocks vs Futures
Futures and stocks are actually more similar than you think. The payoff is extremely similar, but there are some other smaller differences. Probably the most obvious being that futures expire after a given period of time. Stocks can theoretically be held on forever. Furthermore, futures offer leverage and stocks don’t. To control 100 shares of a stock, you’ll have to pay the price of these 100 stocks and that price can be rather high. If you buy one stock, you will profit one Dollar for every one Dollar move in it. A normal amount of leverage on futures is around 1:15 meaning that you can profit 15$ from a 1$ move. But this leverage does vary immensely and depends on the underlying that you plan on trading and the broker that you are using.
Last but not least, the futures market is huge and even bigger than the stock market resulting in even higher liquidity. The higher the liquidity, the better. You can learn more about the importance of liquidity HERE.
Risks And Advantages – Pros And Cons Of Futures
As you probably have noticed by now, futures have certain advantages and disadvantages/risks. Here are some of the most important pros and cons:
- Very good liquidity
- Low commissions compared to other asset classes (depends on broker)
- Physical Delivery. Always close your position before expiration (unless you want to have the physical underlying delivered to you in large quantities)
- Both parties have the obligation to buy/sell asset
- Limited time
When/How To Trade Futures
Futures are quite versatile products that can be used in a variety of scenarios. I won’t go into detail with when exactly you can use certain strategies. But just to give you an idea, futures can be used for all these things:
- Elimination of price volatility (hedging)
- Market impressions
- Pure speculation
As I mentioned and as you can hopefully see, futures are versatile investment products that offer many advantages over other asset classes. Futures are extremely liquid, versatile and easily accessible for retail traders. Furthermore, they can be traded around the clock. Therefore, they are very good investment products. BUT, just like with all other things in the market, you shouldn’t just try them out recklessly. Before trading futures or any other investment products it is essential to educate and inform yourself first. Without the correct education, you will likely lose your money especially with leveraged investment vehicles like futures.
A good alternative to futures are options. These are a little safer than futures and generally a very good introduction to the derivative market. If you are interested in learning more about options, you may want to check out some of my education:
4 Replies to “Futures Trading Explained – Futures vs Options vs Stocks…”
I found your post to be very helpful. I only wish you would have written it and I would have had the opportunity to read it before I made a bad investment in futures years ago. Your advice about being educated and informed before making any kind of investing in futures, stocks, or options is right on point. I was one of those people who did not take the time to get educated on this type of investing and it cost me dearly. You do a good job in laying out the pros and cons and I think anyone reading your article will receive some good information; especially, those who may be as inexperience as I was.
Thanks so much for sharing your story. Others can definitely learn from that mistake.
Thank you for the wonderful and informative article.
As i want to make sure that you and me are on the same page, and i already got the main idea of future trading.
Is it like you put your asset in insurance company, so insurance will compensate you once your property damage or something bad happen.
You have mentioned the oil example that if its price goes down so the company that you sell your asset to, is responsible to compensate you if under the date limit?
Yes, that is basically how it works. A futures contract basically is an agreement to buy/sell an underlying asset at a specific price on a future date. I will use coffee as an example. Let’s say you are the owner of a restaurant that sells coffee. To get the coffee you have to buy it from a coffee farmer. If coffee prices go up, you as the owner of the restaurant would lose money because you need to pay more for your coffee. If prices go down, you make more money because you have to pay less. On the other hand, the coffee farmer loses money due to the drop. To prevent these losses through price movements, the farmer and you (restaurant owner) could buy and sell futures. The farmer would sell a futures contract and you would buy it. This futures contract says that you can buy a certain amount of coffee for a certain price (where no one loses money) on a future date no matter what happens with the coffee price.
So to answer your question: you don’t put any asset into an actual insurance company or anything. You just make an agreement with someone else. But note that this is only one of many uses of futures. You can also use futures for pure speculation even if you aren’t interested in the underlying asset.
Futures vs Options
Differences Between Futures and Options
In this article, we will discuss the importance of futures and options and the role they play in the functioning of the derivatives market.
The derivatives market is the financial market for derivative instruments that derive their value from an underlying value of the asset. The contracts categorized under derivatives are:
- Forwards Contract
- Futures Contract
Futures contracts are agreements for trading an underlying asset on a future date at a pre-determined price. These are standardized contracts traded on an exchange allowing investors to buy and sell them.
Options contracts, on the other hand, are also standardized contracts permitting investors to trade an underlying asset at a pre-decided price and date (expiry date for options). There are 2 types of options: Call Options and Put Options which will be discussed in detail.
Future vs Option Contract Infographics
Let’s see the top differences between futures vs options contract.
There are a number of similarities which exist between these contract which keeps the basics intact:
- Both are exchange-traded derivatives traded on the stock exchanges around the world
- Daily settlement takes place for both contracts
- Both contracts are standardized with a margin account applicable.
- The underlying asset governing these contracts is financial products such as currencies, commodities, bonds, stocks, etc.
- A futures contract is an agreement binding on the counterparties for buying and selling of financial security at a predetermined price at a specific date in the future. On the other hand, an options contract allows the investor the right but not the obligation to exercise buying or selling of a financial instrument on or before the date of expiry.
- Since the futures contract is binding on the parties, the contract has to be honoured on the pre-decided date and the buyer is locked into the contract. Subsequently, an option contract provides just the option but no obligation for buying or selling the security.
- For securing a futures contract, apart from the commission amount paid no advance payments are considered as compared to an options contract which makes it essential to make a premium payment. This is done for the purpose of locking the commitment made by the parties.
- The execution of the futures contract can only be done on the pre-decided date and as per the conditions which have been mentioned. Options contract requires the performance to be done at any time prior to the date of expiry.
- A futures contract can have no limits amounts of profits/losses to the counterparties whereas options contract have unlimited profits with a cap on the number of losses.
- No factor of time decay is important in futures contract since the contract is definitely going to be executed. Whether an option contract will be executed will be much clearer while coming closer to the date of expiry, thus making time value of money an important factor. The premium amount paid also considers this factor while calculations.
- The fee associated with futures trading is easier to understand since most of the fees remain constant and include commissions on the trade, exchange fees, and brokerage. Other expenses pertaining to margin calls are also involved which also does not change much.
In options trading, the options are either trading at a premium or a discount offered by the seller of the option. These can significantly vary depending on the volatility of the underlying asset and are never fixed. Higher premiums are usually tied to more volatile markets and even assets that are priced less expensive can see the premiums rise when the markets head into a period of uncertainty.
Futures vs Options Comparison Table
|Basis of Comparison||Futures||Options|
|Meaning||Agreement binding the counterparties to buy and sell a financial instrument at a predetermined price and a specific date in the future.||A contract allowing the investors the right to buy or sell an instrument at a pre-decided price. It is to be executed on or before the date of expiry.|
|Level of Risk||High||Restricted to the amount of premium paid.|
|Buyer’s Obligation||Full obligation to execute the contract||There is no obligation|
|Seller’s Obligation||Complete obligation||If the buyer chooses then the seller will have to abide by it.|
|Payment in Advance||No advance payment to be made except commission||Paid in the form of premium which is a small percentage of the entire amount.|
|Extent of Gain/Loss||No Restriction||Unlimited Profits but limited loss|
|Date of Execution||On the pre-decided date as per contract||Any point of time before the date of expiry.|
|Time Value of Money||Not Considered||Relied heavily upon|
As discussed above, both are derivatives contracts having its customization as per the requirements of the counterparties. Options contract can reduce the number of losses unlike futures contract but futures offer the security of a contract getting executed at a certain date.
The objective is to protect the interests of the initiator of the contract while speculating the direction of the prices. Accordingly, the buyer and seller can enter into a contract depending on the risk-taking ability and trust in their intuition. Since futures involves the presence of an exchange, the execution of the contract is likely, whereas options do not have such an option but on the payment of a premium amount, one can lock in the contract and depend on where the direction of prices are towards the end of the duration, the contract can either be executed or allow expiring worthless.
This has been a guide to Futures vs Options. Here we discuss the differences and similarities between the two with infographics and comparison table. You may also have a look at the following articles to learn more –
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