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How to Create a Synthetic Put

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Futures and options traders can create a trading vehicle that replicates another trading instrument. Carley Garner, coauthor of Commodity Options: Trading and Hedging Volatility in the World’s Most Lucrative Market, describes an example of a synthetic long put option.

The term synthetic is often used to describe a manmade object that's designed to imitate or replicate some natural object. Futures and options traders can create a trading vehicle, through a combination of futures and options, that replicates another trading instrument. You may wonder why anyone would go through the hassle of mimicking an instrument, instead of simply trading the original. The answer is simple: As the creator of the vehicle, you can customize it to better meet your needs, as well as design it to take better advantage of the underlying market.

Through the creation of a synthetic position, you can actually decrease your delta, as well as (in my opinion) increasing the odds of success. Let's take a look at an example of a synthetic long put option.

Synthetic Long Put Option

Sell a futures contract

Buy an at-the-money call option

When to Use

  • When you are very bearish, but want limited risk.
  • The more bearish you are, the further from the futures (higher strike price) you can buy, although a true synthetic put involves an at-the-money call option.
  • This position is sometimes used instead of a straight long put, due to its flexibility.
  • Like the long put, this position gives you substantial leverage, with unlimited profit potential and limited risk.

Profit Profile

  • Profit potential is theoretically unlimited.
  • At expiration, the breakeven is equal to the short futures entry price minus the premium paid.
  • Each point market goes below the breakeven, profit increases by a point.

What Is at Stake?

  • Your loss is limited to the difference between the futures entry prices and call strike price, plus the premium paid for the option.
  • Your maximum loss occurs if the market is above the option strike price at expiration.

Example

A trader is looking to profit from a decrease in profits, but isn't confident enough in the speculation to sell a futures contract, or even to construct an aggressive option spread that may look to a synthetic put. This strategy has nearly identical risk and reward potential to an outright put, making it a potentially expensive proposition. However, if the volatility and premium are right, it can be a great way to sell a futures contract, while retaining peace of mind and the ability to adjust the position easily.

In early 2007, the Treasury market found itself caught in a trading range that spanned nearly a month. The lack of direction successfully imploded option premiums associated with the complex. According to hypothetical values available to us, at the end of March a trader may have been able to purchase a June 2007 T-Note 109 call option for about $750. At that point, the option would have had just over three months of time value and provided a relatively lengthy and inexpensive opportunity to ensure a short futures trader against an adverse price move in the futures market. In other words, a trader could have simultaneously purchased the call and sold a futures contract knowing that the absolute risk was $750 plus any difference in the fill of the futures contract and the strike price of 109 (see Figure 1).

The same trader would be facing theoretically unlimited profit potential and three months in the market essentially worry-free beyond the cost of the insurance (call option). With that said, in order for this trade to be profitable at expiration, the futures price would have had to move enough in favor of the trader to overcome the premium paid for the option. In this case, that's about 24 ticks. Assuming that the trader was able to sell the futures contract at 109 exactly, the profit zone would be at 108'08 (109 - 24/32).

The payout of this trade at expiration may be identical to a long put option, but the flexibility provided to the trader is unmatched. Unlike a long put, a synthetic long put can be pulled apart prior to expiration in an attempt to capitalize on market moves. (Please note that doing so greatly alters the profit-and-loss diagram.)

An example of an adjustment may be to take a profit on the short futures contract and hold the long call, in hopes of a subsequent market rally and the possibility of being profitable on both the futures position and the long option. Or, should the trade go terribly wrong from the beginning, a trader may look to take a profit on the long call and hold the short futures in hopes of a reversal. Doing so would eliminate the insurance of the long call and leave the trader open for unlimited risk on the upside, but may be justified if the circumstances are right.

Carley Garner is the senior analyst at DeCarley Trading LLC, where she also works as a broker. She is a coauthor of Commodity Options: Trading and Hedging Volatility in the World's Most Lucrative Market, published by FT Press. Visit DeCarley Trading's website for a free subscription to Carley's e-newsletters, The Stock Index Report and The Bond Bulletin, and for details on the services she provides.

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