What it means
A call option gains when the price rises and a put option gains when the price falls. If an investor buys a call and sells a put at the same strike, a rising price makes the call valuable and a falling price makes the put (which the investor sold) costly.
Put together, the two legs track the price of the asset almost one for one. This replication is called a synthetic long.
The idea is useful because it can require much less cash upfront than buying the asset, and the premium received from selling the put partly or fully pays for the call. In some markets it also lets investors take a position when the asset is hard or expensive to borrow or buy directly.
The risks are as large as owning the asset. If the price drops sharply, the investor who sold the put must buy the shares at the strike price, so the loss can reach the strike price minus the net premium, times the shares covered.
The position also needs margin because of the short put. The link between the call, put and shares is also the basis of put-call parity, a pricing relationship that stops option prices from drifting out of line with the share price.
Professional traders use parity to find mispricings and to build arbitrage trades. Variants exist for other views.
A short synthetic reverses the legs, selling the call and buying the put, to imitate a short position in the asset.
In practice
Real-world examples.
Example
A trader believes a mining stock will rise but does not want to tie up $50,000 buying shares. She builds a long synthetic using options and posts margin instead, leaving cash free for other trades.
Example
An arbitrage desk notices that a call is priced too cheaply relative to the put and the shares. It builds a synthetic long and sells the actual shares, aiming to lock in the pricing gap.
Example
A fund holding cash wants exposure to a stock index for a few weeks without trading the underlying shares. It uses index options to create a synthetic long and removes it by closing both legs.
Formula
Calculation
Long synthetic = Long call + Short put (same strike, same expiry)
Net cost = Call premium - Put premium
Profit at expiry = (Share price at expiry - Strike price - Net cost) x Shares covered
Suppose a share trades at $100. An investor buys a $100 call for $6 and sells a $100 put for $5, covering 100 shares.
Net cost = $6 - $5 = $1 per share, or $100 in total.
If the share finishes at $115, profit = ($115 - $100 - $1) x 100 = $1,400.
If the share finishes at $90, loss = ($90 - $100 - $1) x 100 = -$1,100.
Owning the shares directly would have made $1,500 and lost $1,000 respectively, so the synthetic tracks the shares apart from the small net premium difference.Case study
Seen in the real world.
Blue Harbour Partners is an illustrative, fictional trading firm that wanted exposure to a shipping company ahead of a seasonal rise in freight rates. Buying the shares would have required $200,000, which was more than its risk limit allowed for a single position.
The head trader built a long synthetic by buying a call and selling a put at the same strike, for a net premium of almost nothing. The position moved with the shares, and when the price climbed 12% the firm closed both legs and booked a gain close to what share ownership would have produced.
In the same illustrative story the trader had a rule to treat the short put as if it were stock already owned. That discipline kept the firm from underestimating the downside, which was every bit as large as holding the shares.
Watch out
Common mistakes.
- Treating a long synthetic as low risk because little cash is paid upfront, when the potential loss is similar to owning the asset.
- Using different strikes or expiry dates for the two legs and expecting the position to track the asset exactly.
- Forgetting that a short put can be assigned early on some options, forcing a purchase of shares sooner than planned.
Questions
People also ask.
Does a long synthetic pay dividends?
Not directly. The option prices already reflect expected dividends, so the position does not receive them, but it benefits from the way they are priced in.
Why use a synthetic instead of buying shares?
It can need less capital, can avoid some trading restrictions, and may be cheaper in some markets, but it adds margin requirements and complexity.
What is the difference between a long synthetic and a collar?
A collar combines owned shares with a bought put and a sold call, whereas a long synthetic creates the share exposure itself from options.
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