A synthetic position is a trading strategy where an investor creates an artificial position that mimics the characteristics of another position. In the context of futures, a synthetic futures position might involve combining options (call and put options) to replicate the payoff profile of a futures contract. This can be done to gain exposure to price movements in the underlying asset without directly trading the futures contract.

For example, if an investor believes that the price of a stock will rise, they might create a synthetic long futures position by buying a call option (which benefits from upward price movements) and selling a put option (which benefits from stable or rising prices). This combination can create a risk and return profile similar to holding a long futures contract.

Buying Synthetic futures

When we talk about “buying synthetic futures,” we are usually referring to a trading strategy that mimics the payoff of a traditional long futures position through the use of options. This strategy is known as a synthetic long futures position. It involves combining a long call option with a short put option, both having the same strike price and expiration date.

Here are the basic components of a synthetic long futures position:

• Long Call Option:
  • The investor buys a call option, which gives them the right (but not the obligation) to buy the underlying asset at a specified price (strike price) before or at the expiration date.
  • The long call benefits from upward price movements in the underlying asset.
• Short Put Option:
  • Simultaneously, the investor sells a put option with the same strike price and expiration date as the long call.
  • The short put obligates the investor to buy the underlying asset at the strike price if the option is exercised by the option holder.
  • The short put benefits from stable or rising prices in the underlying asset.

By combining these two options, the investor creates a position that behaves similarly to owning a long futures contract. Here’s why:

• Profit Potential: The synthetic long futures position profits when the price of the underlying asset rises. The long call gains value with upward price movement, while the short put contributes to the position’s profitability as long as the price remains above the strike price.
• Risk: The risk is limited to the net premium paid for the long call option. If the price of the underlying asset falls below the strike price of the options, the short put will start losing value, but the losses are offset by the gains in the long call.
• Break-Even: The break-even point is the strike price of the call option plus the net premium paid for the options. Above this level, the position starts making a profit.

It’s essential to note that while a synthetic long futures position can replicate the payoff of owning a futures contract, it also involves the risks associated with options trading. Traders should carefully consider factors such as implied volatility, time decay, and transaction costs.

As with any trading strategy, it’s recommended to thoroughly understand the mechanics, risks, and potential rewards before implementing it.