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Options trading: What Exactly Is a Synthetic Derivative?

By  May 24, 2012

Topics: Finance & Investing

Everyone heard about the problems at JPMorganChase - losing $2 billion or more writing "synthetic derivatives" - but what exactly does that mean?

It's a journalistic disservice when financial reporters write what happened but then do not explain what it means. The JPM story is one example.

A "synthetic derivative" sounds pretty ominous, mainly because few people understand what exactly that is. Perhaps the problem is that many reporters don't know either, so they just put that in the story and let it sit.

Synthetic derivatives are option combinations designed to mirror the performance in the underlying security, but for little or no cost. For example, any time you open one long and one short option,t he cost of the long side is partly or completely offset by income from the other side. So it is possible to create a synthetic derivative for no net cost, and have the position move exactly like the stock, ETF or index on which it is written.

Synthetic long stock will move upward point for point when the stock moves up. It consists of a long call and a short put.

Synthetic short stock does the opposite; it grows in value when the underlying security moves down. It consists of a long put and a short call.

These are elegant strategies that create the most power leverage possible. They allow you to benefit from price movement of stock but without having to put all of the money at risk. For example, a synthetic derivative on Google can be created for zero net cost or close to it. The alternative, buying 100 shares, costs over $60,000 because the stock price is over $600 per share.

So what went wrong with JPM? A synthetic derivative is a great way to profit in the market with maximum leverage, but only when the underlying moves in the direction you expect. A synthetic short position includes a short call, meaning if the underlying rises, that call is exercised and the result is a net loss (the loss is equal to the difference between the short call's strike and market value per share at the time of exercise).

In a synthetic long position, you expect the underlying to rise. But if it falls, the short put is exercised and you have to buy shares at the strike, creating a loss. That loss is equal to the strike price at which the underlying is put to the writer, minus the current market value at the time of exercise.

Without knowing exactly what kind of synthetic derivative JPM opened, it's impossible to know exactly how the loss occurred. But whether long or short, it could be a position on a stock, future, ETF or index; and the loss is determined by the number of positions opened and the point spread between strike and exercise.

Does this mean synthetic derivatives are bad? Not at all. This is one of many excellent strategies that options traders can use in many ways. The flaw is in the investment manager whose guidance was weak, or who violated the guidance by reckless trading that created these losses. This may be allowed by ill-defined policies or allocation models used by a company, or simply a matter of too much greed and too little common sense.

The bottom line is this: The problem is not with derivatives, but with how they are used. In the JPM case, obviously, someone made a decision that turned into a disaster.