Your guide to synthetics in trading

Synthetics in trading refers to financial instruments developed to mimic different assets with certain key characteristic adjustments, such as duration, exposure and cash flow. These synthetics are designed to replicate the underlying performance of the target assets while providing custom cash flow patterns and risk profiles.

There are a number of methods used to create a synthetic position. A popular example in the options market is buying an ‘at the money’ call and simultaneously selling an ‘at the money’ put on the same underlying stock to approximate the stock’s performance.

By using synthetics, investors can create customized investment strategies that better fit their risk tolerance and market view. These products can be used to replicate the performance of other financial instruments, such as stocks, commodities or bonds, so you can get similar results with certain key adaptations that appeal to the trader.

Creating synthetic positions

A synthetic position can be created by combining different financial instruments, such as options and stocks. These positions allow you to replicate an existing position or create a new risk profile without actually holding the underlying stock or option position.

• Adjusting existing positions: You can use synthetics to adjust an existing position when your view changes, minimising transaction costs.
• Arbitrage opportunities: Synthetics can be used in arbitrage trading strategies to exploit pricing inefficiencies.
• Fewer transactions: By using synthetics, you can get the same results with fewer transactions and thereby more efficiency.

Adapting exposure and holding period: Using derivative products like options can approximate exposure with less upfront capital while adding discreet time for market exposure

Creating a synthetic position requires a deep understanding of the underlying assets, market conditions and cash flow patterns to manage risk profiles effectively.

Types of synthetic options positions

Among the wide variety, below are six types of popular synthetic options positions with each serving different purposes and trading strategies. Those engineered positions are: 

Synthetic long stock

A synthetic long stock position mimics the outcome of owning the actual underlying stock but uses options to approximate. To create this position, an investor buys at-the-money (ATM) call options on the stock and writes (or sells) at-the-money put options on the same stock. 

The cost of buying the calls is at least partially offset by the premium received from writing the puts. If the underlying stock’s price remains unchanged at the time of the options’ expiration, the cost or return will be limited to the original outlay. 

If the stock’s price increases, the calls rise in value. If the stock’s price decreases, the puts result in equivalent losses, down to the stock hitting zero. These results can be virtually identical to holding the actual stock. The benefit with this position is leverage, as the capital required to take a synthetic long stock position is generally lower than the cost of buying the underlying stock outright. That said, there is also a limit to the exposure time in the trade equivalent to the options’ expiration date. 

Synthetic short stock

A synthetic short stock position replicates the outcomes of short-selling stock, only through options exposure. To establish this position, a trader sells at-the-money call options on the stock and buys equivalent at-the-money put options on the same stock. 

If the stock’s price remains unchanged, the outcome in the synthetic position is general neutral because the cost of buying the puts is at least partially offset by the premium earned from selling the calls. If the stock’s price falls, the purchased puts will rise in value up to the point of the stock hitting zero. However, if the stock’s price increases, the written (sold) calls generates losses equivalent to the stock's upside (which is potentially unlimited). Therefore, the profit and loss potential in this strategy would be roughly the same as short selling a stock. 

There are two advantages to synthetic short stock. The first is leverage, similar to the synthetic long, as less capital is needed compared to traditional short-selling. The second relates to dividends. When short-selling an actual stock, traders are obliged to pay the equivalent dividend if the corporation pays out dividends to shareholders. This obligation doesn’t exist with an options-derived synthetic short stock positions, making them potentially more cost-effective. 

Synthetic long call

A synthetic long call position is created by buying a put option as well as the relevant underlying stock. To establish this position, a trader purchases the underlying stock and buys put options on the same stock. 

This combination mirrors the payoff of owning a call option with a capped downside should the underlying fall while maintaining potentially unlimited upside. The synthetic long call is typically used when an investor owns the underlying and expects the stock price to potentially fall in the interim, but expects the stock to eventually continue higher over time. 

Instead of purchasing call options, the trader can achieve a similar result by buying the underlying stock and holding put options. This can cap downside losses should the market be seen falling temporarily without having to unwind the underlying exposure.

Synthetic short call

A synthetic short call is designed to replicate the characteristics of a short call option position. To do this, a trader short sells the underlying stock and writes (sells) put options on the stock.

This position is often used when an investor is already short on the underlying stock but then expects the stock price to increase at least temporarily, and eventually return to a larger decline. Instead of closing the short stock position, they can sell puts in the underlying to cap losses on the upside beyond a certain level, replicating a short call payoff. Again, this can allow those unwilling to unwind an underlying position (short in this case) to maintain exposure while adjusting the position to match the trader’s new expectations. 

Synthetic long put

A synthetic long put position mirrors the results of holding outright put options in an underlying market but uses a combination of stock exposure and call options. To create this position, an investor short sells the underlying stock and buys call options on the stock. 

This strategy is typically used when an investor was already short a stock but anticipates an interim rebound in the underlying’s price before returning to the larger decline. Instead of buying back the stock, they can buy calls to cap losses during a market bounce without having to exit the underlying. 

Synthetic short put

A synthetic short put position recreates the outcomes of writing a put option but is constructed differently. To establish this position, an investor buys the underlying stock and writes (sells) call options on the stock.

This position is usually established by someone who is long the underlying stock and expects the market to stall through the foreseeable future. Instead of closing out the underlying stock position, they can write calls to earning the premium on the exposure. The combination of owning stocks and having a short call position on that stock creates a synthetic short put, which approximates the same potential profits and losses as holding a standard short put position.

Trading synthetic indices

Trading synthetic indices is the process of creating a synthetic position that mimics the performance of an underlying index or financial instrument. This allows you to get exposure to a particular market or sector without actually owning the underlying stock or other instruments.

• Hedging potential losses: Synthetic indices trading can be used as a correlated or thematic hedge to offset potential losses in existing positions.
• Market speculation: Traders use synthetic indices to speculate on market moves without actually investing in a particular underlying asset or assets.
• Portfolio diversification: By using synthetic indices, you can diversify your portfolio without the onerous transaction costs of buying multiple individual assets.

Trading synthetic indices requires a trading account and a good understanding of trading strategies.

Key advantages of using synthetic positions in financial strategies

Synthetic positions offer many potential benefits to investors, including flexibility, cost-effectiveness, risk management, and leverage: 

Flexibility

Synthetic positions provide additional flexibility in managing investment strategies. Investors can use options contracts to mimic the price movements of stocks, futures, or other assets, allowing them to gain exposure to different markets without needing to own the underlying assets and adding flexibility through multiple ‘legs’.

Investors can also adjust positions based on shifting market conditions, allowing them to pivot more quickly than with traditional investments or completely withdrawing from the market itself. 

Cost-effectiveness and leverage

Synthetic positions are often more cost-effective than directly buying or selling underlying assets. Because options generally require smaller premiums compared to outright asset purchases, synthetic positions allow investors to achieve similar exposure with lower upfront costs. This can be beneficial for investors wanting to diversify without tying up too much capital. It can also affect larger gains on the initial exposure for leverage.

That said, leverage can also increase risk, which investors must consider before adopting these strategies. 

Risk management

Synthetic positions can also offer a way to manage risk. By combining options contracts in different ways, investors can hedge against potential scenarios that would otherwise represent greater (perhaps even unlimited) losses and reduce exposure to market volatility. 

For example, using a synthetic long call – where an investor buys a put option and is long the underlying stock – can maintain the theoretically unlimited upside of a stock while creating a floor should the market reverse. If the underlying asset’s price drops, the put option will increase in value and offset the losses in the underlying position.

New trading opportunities

Synthetic positions can also provide new trading opportunities compared to traditional investments, allowing investors to mimic the payoff profiles of different assets and exploit market efficiencies. 

Consider a synthetic short straddle position, for example, which is created by buying a call and put option with the same strike price and expiration. This position can be beneficial if an investor anticipates a decrease in market volatility. If the stock’s price remains stable, the investor can profit from the decline in the options’ premiums, providing an opportunity not typically accessible through traditional investing methods.

Benefits and risks of trading synthetics

Trading synthetics can offer significant benefits, but can also present risks that you should consider.

Benefits:

• Customised investment strategies: You can tailor financial instruments to your investment goals.
• Hedging against losses: Synthetic positions can be used to hedge against losses in your existing positions.
• Efficient use of capital: Synthetics allow you to get market exposure without actually buying the underlying asset.
• Flexibility in trading strategies: You can construct synthetic positions to take advantage of market opportunities otherwise not available in traditional assets.

Risks:

• High-risk, high-reward liabilities: Synthetics can potentially amplify both gains and losses.
• Complexity: Understanding synthetic options and synthetic short call positions requires experience and knowledge of financial markets.
• Liquidity issues: Some synthetic financial instruments may have lower liquidity relative to their underlying, affecting trade execution.

Real-world applications of synthetics

Synthetics play a big role in financial markets. Here are some of the real applications that are used by traders and institutional investors:

• Hedging strategies: Synthetics are used to hedge against currency fluctuations, interest rate changes and stock market volatility.
• Market speculation: These engineered exposures can allow for approximate broader ‘market’ exposure for thematic views.
• Arbitrage trading: Synthetics are used in arbitrage strategies to exploit price discrepancies in financial markets.
• Creating synthetic indices: Institutional investors use synthetic indices to get exposure to specific market sectors without actually holding the components.

By using synthetics, you have more flexibility to control your investment outcomes while potentially better managing risk.

Synthetic prime services

StoneX Global Prime Services offers OTC total return swaps as an alternative to traditional cash financing solutions. This flexible solution enhances liquidity and diversification, meeting the strategic needs of modern financial institutions.

Learn more about our synthetic prime services and financing solutions.

Best practices for trading synthetics

To trade synthetics successfully, traders must follow best practices and risk management:

• Know the markets: Deep understanding of underlying assets, the derivative legs and trading strategies.
• Risk management: Position sizing and risk mitigation techniques to prevent large losses.
• Trading account with good tools: Synthetic exposure via the likes of indices and options requires a reliable platform with advanced tools.
• Stay informed: Keep up to date with market trends and financial instruments to make informed decisions.
• Don’t overleverage: While synthetics can utilize forms of leverage to increase returns, they can also increase risks if misused.

Why choose StoneX Prime?

• Comprehensive multi-asset coverage: Execute trades across a broad range of asset classes, including equities, fixed income, FX, and more.
• Advanced technology: Leverage our low-latency market access and algorithmic solutions for superior trade execution.
• Global market reach: Trade in over 140 currencies across 180+ countries with direct access to 87+ securities markets and 36+ derivative exchanges.
• Expert support: Benefit from our experienced trading desk and sales support team, available 24/7.
• Regulatory compliance: Ensure your trades meet all regulatory requirements with our compliance-focused services.

Optimize Your Trading with StoneX Prime

At StoneX Prime, we are dedicated to providing our clients with greater control over their trades, reduced transaction costs, and improved price execution. Our team of experienced traders and brokers uses cutting-edge technology and comprehensive market data to ensure your investment decisions are supported by the best execution practices.

Learn more about StoneX Prime Services.

Conclusion

Trading synthetics gives you a powerful tool to create customised investment strategies and cash flow patterns. By knowing how to create a synthetic position, you can replicate the performance of underlying assets with potentially lower outlay and greater flexibility in subsequent exposure adjustments in the ‘legs’ of the setup.

While synthetics can be used to hedge against losses and increase the efficient use of capital, they come with big risks. Investors must have a good understanding of financial instruments, risk profiles and market conditions before exploring these more complicated structures.

Whether you want to go long on a market sector through synthetic indices or adjust an existing position through options, mastering synthetics can represent a meaningful adaptation to aid one’s market approach.

FAQs

How are synthetic assets created?

Synthetic assets are built by combining different financial instruments, usually options or swaps, to copy the behavior of another asset. One common way to create a synthetic position is by using options, like buying a call and selling a put on the same stock, to mimic how that stock would perform. Sometimes traders also use a mix of stock and options, depending on what they want to achieve.

The idea is to recreate the returns, risks, or cash flows of the real asset without actually owning it. Setting up a synthetic position usually takes a good understanding of how the underlying markets move and how the different instruments interact. It’s all about managing exposure, cash flow, and risk in a way that matches your goals.

What types of synthetic financial instruments exist?

There’s a wide range of synthetic strategies you can use, depending on what you’re trying to do in the market. Some of the most common types include:

• Synthetic long stock: Buying a call and selling a put to mirror the returns of owning the stock.
• Synthetic short stock: Selling a call and buying a put to behave like you’ve shorted the stock.
• Synthetic long call: Owning the stock while buying a put option to protect against downside but keep upside potential.
• Synthetic short call: Shorting the stock and selling a put to limit upside risk without closing the short.
• Synthetic long put: Shorting the stock while buying a call to cap losses if the stock bounces.
• Synthetic short put: Owning the stock and selling a call to earn premium if the stock holds steady.

There are also synthetic indices and total return swaps that let investors gain broader exposure without having to own dozens of individual assets. Institutions often use these for strategic hedging or financing.

How do synthetic assets differ from real assets?

The biggest difference is ownership. When you hold a real asset, like a stock or bond, you actually own it. With a synthetic asset, you’re using other tools such as options or swaps to copy how that asset behaves without ever really owning it.

Synthetics often cost less upfront, which can free up cash and give you more flexibility. They can also be tailored to fit specific market views or risk levels. But they do come with trade-offs. Synthetics can be more complicated, sometimes expire after a certain time, and might not be as easy to trade as the real thing.

In short, synthetics let you get similar results to real assets, but with more customization and more complexity.