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What Are Synthetic Shares
Synthetic shares are financial assets used to create the same payoff pattern as investing in an underlying stock.
For instance, you can use a combination of put options and call options where the underlying assets are equity stocks to create a synthetic stock position.
When you create a synthetic stock position, you are effectively duplicating the stocks’ profit and loss patterns as if you were holding the stock in question.
You can create synthetic shares by taking a long or short position on the stock in question.
If you take a long synthetic position in a stock, you will duplicate the profit and loss patterns of going long in the stock in question.
Similarly, if you take a short synthetic position in a stock, you will duplicate the profit and loss patterns of going short in the stock in question.
Option Contracts
Since you are using equity option contracts to create a “synthetic stock” or a position where you are duplicating the profit and loss patterns of owning a stock, your position will be multiples of 100 shares.
Every options contract allows you to control 100 shares of the underlying stock.
So whenever you create a synthetic position using options, you are working based on the multiple of 100 shares.
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Long Synthetic Position
A long synthetic position is when you buy a call option and sell a put option on the same underlying stock.
The put option and call option must have the same strike price and expiration date.
For example, you buy a call option allowing you to buy a stock at $50 per share with an expiration of the contract two months from today.
Simultaneously, you buy a put option giving you the right to sell a stock at $50 per share with an expiration of the contract two months from today.
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Short Synthetic Position
A short synthetic position is created by buying a put option and selling a call option, both having the same strike price and expiring at the same time.
The short synthetic position is effectively the opposite of the long synthetic position.
For example, when you buy a put option and sell a call option, you are betting that the underlying stock price is going down in a similar way that a short seller would short the stock.
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Advantages of Synthetic Shares
The main advantage of creating a synthetic position in a stock is that you can generate the same profits as if you bought the stock directly but without paying full price for the shares.
In other words, you can capture the same amount of profits as if you opened a long stock position by investing a fraction of the money that you would have needed to buy the stocks directly.
Another advantage of creating a synthetic stock position is that you can simulate a short position without having to comply with the rules typically applicable to shorting a stock.
In some cases, it may be difficult to short a stock directly.
However, with a short synthetic position, you simulate a short position on the underlying stock without having actually to borrow any shares for the short position.
Savvy traders can use synthetic share positions to complement their trading strategies and even hedge against risk.
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Disadvantages of Synthetic Shares
Although synthetic shares have some advantages, you should also be aware of their disadvantages.
One important disadvantage is that since you are trading derivatives, you should be mindful that if the market goes in a direction you did not predict, you can lose significant sums of money.
Trading options means that you must honor your option contract and be able to cover your position or close it.
Another disadvantage with synthetic shares is that your options contract has an expiration date.
As a result, the synthetic position you create will only last for a short time.
If you are unable to profit from your synthetic stock position and your options expire, you will lose your investment.
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Synthetic Shares Example
Let’s look at an example of how you can create a synthetic share position to increase your returns.
One technique is to create a synthetic position based on the long stock positions you currently have in your portfolio.
For example, if you own shares of a dividend-paying stock but expect the stock price to go down due to the market conditions, you can create a short synthetic position on your stocks to hedge against the dropping prices.
By remaining long in the dividend-paying stock, you continue to receive your dividend income.
However, since you created a short synthetic position on the same stock, you are protected if the price goes down as your synthetic position will go in the money.
If you own the underlying stock and you create a synthetic position on top of it, you can also choose to buy or sell additional option contracts to augment your profits or mitigate risk further.
Since you are trading options, a smart trader finds creative ways to increase his or her profits or mitigate against possible losses.
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Synthetic Shares FAQ
What is a synthetic share?
Synthetic shares refer to the creation of a financial position simulating the profit and loss patterns of an underlying stock without investing in the stock directly.
Using derivatives like call and put options, you recreate the same payoff patterns as the underlying stock without having to invest full price to purchase the stock.
Also, since every options contract is for a lot size of 100 shares, you also can benefit from the leverage of controlling more of the stock at a fraction of the cost.
Is it illegal to have synthetic shares?
There is nothing illegal about creating a synthetic share position.
However, although it’s legal for you to create a synthetic position by trading options, you should be mindful of the risks associated with such trades.
Beginners should avoid embarking on such trading strategies.
As for the professionals, creating synthetic shares should be part of an overall investment strategy aimed at improving your returns without exposing yourself to significant losses.
How risky are synthetic shares?
Creating a synthetic position should be done with care and a lot of prudence.
You should keep in mind that you have an unlimited upside in making a profit, making synthetic shares highly attractive.
However, the opposite is also true.
If the market goes in the wrong direction, you are also exposed to an unlimited downside.
The profits and losses on a long synthetic position are not capped.
Takeaways
So there you have it folks!
What are synthetic shares?
In a nutshell, synthetic shares refer to the process of using different financial instruments to recreate the payoff of a stock position.
In essence, you are using certain financial instruments to recreate the payoff patterns of a long or short stock position.
The main advantage of creating a synthetic stock position is that you can capture the same payoff as if you invested in the stock directly but at a fraction of the investment cost.
Now that you know what synthetic shares are and how they work, good luck with your research!
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