What it means
A futures contract is a standardised agreement, traded on an exchange, to buy or sell an asset at a set price on a future date. Profits and losses are settled every day through margin accounts.
They are popular for commodities, currencies, interest rates and stock indices. A synthetic futures position copies that exposure with options.
A long synthetic future is built by buying a call and selling a put at the same strike and expiry. A short synthetic future uses the opposite pair, selling the call and buying the put.
Why would anyone choose this route? The options may be priced attractively relative to the future, the trader may want to hold a position through a different margin treatment, or the future may be hard to trade in the quantity wanted.
Professional traders also compare the synthetic with the actual futures price, and if the two differ by more than costs, they can profit by trading the gap. There are risks.
The short option leg carries a large potential loss, and the position requires margin that can rise when markets are volatile. Options can also be less liquid than futures, which makes it harder to close the position at a fair price.
Another sense of the term is a futures position replicated with cash and borrowing. The fair price of a future depends on the spot price and the cost of carry, which is the cost of financing and storing the asset until delivery.
A trader who buys the asset with borrowed money has built a synthetic future in the sense that the result mirrors a futures position. For a non-specialist, the practical lesson is that equivalent exposures can be built in more than one way.
The right choice depends on cost, liquidity and the risk limits of the business.
In practice
Real-world examples.
Example
A trader wants to hold a long position in crude oil but believes the option market is pricing in too little volatility. She builds a synthetic long future and compares the cost with the actual future.
Example
A fund is restricted from holding futures directly but is allowed to hold exchange-traded options. The manager creates a synthetic futures position to achieve the same exposure within the rules.
Example
A commodity firm sees that the synthetic price from options is $5 a barrel below the actual future. Its trading desk buys the cheaper synthetic and sells the future, locking in the gap as a profit before costs.
Formula
Calculation
Synthetic long futures = Long call + Short put (same strike and expiry, on the same future)
Payoff at expiry = Futures price at expiry - Strike
Suppose a gold futures contract covers 100 ounces and the futures price is $2,000 an ounce. A trader buys a call with a $2,000 strike for $40 an ounce and sells a put with a $2,000 strike for $40 an ounce, so the net premium is $0.
If the futures price rises to $2,100: payoff = $2,100 - $2,000 = $100 an ounce, or $100 x 100 = $10,000.
If it falls to $1,900: payoff = $1,900 - $2,000 = -$100 an ounce, or -$100 x 100 = -$10,000.
A direct long futures position at $2,000 would give identical results of +$10,000 and -$10,000.Case study
Seen in the real world.
Northfield Capital is an illustrative, fictional trading firm that monitors the relationship between futures prices and option prices on a stock index. One morning the synthetic futures price implied by options was 8 index points lower than the actual future.
Each index point was worth $50 on its standard contract, so the gap was worth 8 x $50 = $400 per contract. The desk bought the synthetic position, sold the real future and held the pair until expiry, when the two prices converge.
In the illustrative result, trading 200 contracts earned 200 x $400 = $80,000 before costs of $12,000 in fees and margin financing. The profit of $68,000 depended on both legs being executed quickly, and the risk team noted that a delay could have wiped out the gain.
Watch out
Common mistakes.
- Treating the synthetic as risk free because it copies a familiar future, when the short option leg can lose heavily.
- Ignoring option liquidity, which can make it costly to close the position.
- Mixing strikes or expiry dates, which means the payoff no longer matches the future.
Questions
People also ask.
What is the difference between a synthetic forward and a synthetic futures contract?
The construction is the same, but the futures version uses options on a futures contract and is subject to exchange margining.
Why might a trader prefer a synthetic?
Reasons include different margin treatment, access, pricing differences between the option and futures markets, and trading restrictions.
How does arbitrage keep prices aligned?
If the synthetic and the real future differ by more than costs, traders buy the cheaper and sell the dearer, which pushes the prices back together.
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