Synthetic Long and Short Futures Positions Using Options

Stock exchange, futures traders, Toronto, Ontario, Canada
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The definition of synthetic is something that is prepared or made artificially. In markets, there are many different ways to express a particular price bias. Classically, bulls buy and bears sell. However, the advent of derivative instruments in all asset classes has presented traders and investors with many different components for their market toolbox. Commodities are no exception. One of the most interesting derivative instruments, which have become very popular over recent decades, is options.

A buyer of options receive the right, but not the obligation, to buy (or sell) a specified amount of an asset at a specified price (the strike price) for a specified period (until the expiration date). While traditional market vehicles allow participants to express bullish and bearish bias, only options permits a market participant to bet that a market will go nowhere. Selling a combination of options allows traders and investors to bet on and profit from an asset that remains static with its price unchanged over time.

Options are flexible tools. As you learn more about the properties of these instruments, a world of possibilities opens. In a recent piece, I explained the concept of put-call parity. In this piece, I will take that concept a step further and describe synthetic long and short futures positions as well two market positional structures, risk reversals and conversions.

A long call option is an instrument that is a bullish vehicle.

It offers the buyer the ability to make money if prices go higher. A long put option is an instrument that is a bearish vehicle. It offers the buyer the ability to make money if price go lower. Buying both at the same time, in the same vehicle with the same strike price and same expiration date allows the buyer to make money if the market moves a lot in either direction, this combination is a straddle.

Selling both and collecting the premium allows the seller to make money if the market in the underlying asset remains static or it does not move. However, these options, in combination, can also create synthetic long or short positions:

The synthetic long position- the purchase of a call option and simultaneous sale of a put option on the same asset with the same strike price and expiration creates a synthetic long position in the underlying asset. The purchase of the call is bullish and the sale of the put is also bullish.

The synthetic short position- the purchase of a put option and simultaneous sale of a call option on the same asset with the same strike price and expiration creates a synthetic short position in the underlying asset. The purchase of the put is bearish and the sale of the call is also bearish.

Risk reversals and conversion structures take these concepts one-step further. A risk reversal has different definitions when it comes to commodity and currency trading. In commodities, a risk reversal is a hedging strategy that consists of selling a call option and buying a put option. The strategy protects against a price movement to the downside. In currencies, the risk reversal is the difference in implied volatilities between similar call and put options.

The chief determinate of option premiums is implied volatility therefore; monitoring risk reversal levels provides important market information. If call volatility is much higher than put volatility, this implies a bullish market consensus. Conversely, if put volatility is higher than call volatility it implies a bearish market consensus. Keep in mind that the upside for any market is naturally greater than the downside, regardless of price. This is because theoretically a market can go up to infinity while it is limited on the downside to zero. Therefore, in normal market conditions, call options are always slightly more expensive than similar put options.

A conversion is a strategy that closes or flattens a synthetic long position or short position by employing the underlying vehicle. Selling the underlying asset against a synthetic long position results in a conversion.

Conversely, buying the underlying asset against a synthetic short position results in a conversion. The conversion is a three-legged trade, which results in a flat or riskless position.

Options are amazing tools and understanding them opens a completely new world of information for market participants.