Synthetic Positions

A synthetic position is a combination of options, and sometimes the underlying, that produces the same payoff as a different position. Because of put call parity, calls, puts and the underlying are linked so tightly that any one can be built from the other two. Traders use synthetics to get the same exposure more cheaply, with less capital, around restrictions such as short selling limits, or to spot mispricing between equivalent positions.

The six basic synthetics#

All of these use options with the same strike and expiration.

The last line explains why a covered call (long stock plus short call) has the same shape as a short put. See Covered Call and Short Put.

Where they come from#

Put call parity states:

call - put = stock - present value of strike

Rearranging the terms gives each synthetic. For example, moving the put to the right side gives call = stock + put minus cash, which is why a protective put (stock plus put) behaves like a long call. See Put-Call Parity.

Synthetic long stock#

Why traders use synthetics#

• Capital efficiency: a synthetic long ties up margin rather than the full value of the shares.
• Hard to borrow stocks: a synthetic short (short call plus long put) can replace short selling when borrowing is difficult, though option prices often reflect the borrow cost. See Borrow Fees and Stock Loan Costs.
• Arbitrage: if a synthetic is cheaper than the real position, traders buy the synthetic and sell the real one. Conversions and reversals do exactly this. See Arbitrage Strategies.
• Adjusting positions: a trader with a long call who wants to remove upside exposure can add short stock, turning it into a synthetic put without closing the call.

Risk reversals#

A close relative of synthetic long stock uses different strikes: buy an out of the money call and sell an out of the money put. This is called a risk reversal. It gives bullish exposure that starts beyond the strikes and is a common way to express a directional view or to measure skew, the price difference between out of the money calls and puts. See Volatility Smile and Skew and Skew Trading.

Things that break the equivalence#

Synthetics match their targets closely but not perfectly:

• Dividends: shareholders receive dividends; option holders do not.
• Interest: the cost of carrying the shares is built into option prices.
• Early exercise: American options can be assigned early, splitting a synthetic apart. See Exercise and Assignment.
• Pin risk at expiry: if the stock closes at the strike, it can be unclear which leg is exercised.
• Margin and fees: these differ between synthetic and real positions.
• Voting rights: only shareholders have them.

Common mistakes#

• Thinking a synthetic long has less risk than owning the stock. The downside is the same.
• Ignoring early assignment on the short leg.
• Comparing synthetic and real costs without including dividends and interest.

Frequently asked questions#

What is a synthetic position in options?#

A combination of options, and sometimes the underlying, that replicates the payoff of another position, such as a long call plus a short put copying long stock.

Why would someone use a synthetic long stock?#

To get stock like exposure with less capital, or to take advantage of pricing differences, while accepting the same downside risk as owning shares.

Are synthetic positions risk free?#

No. They carry the same market risk as the positions they copy, plus risks from early assignment, dividends and margin.

Next, learn how option prices respond to changing conditions in The Option Greeks Explained.