Synthetic position
Encyclopedia
In finance
, a synthetic position is a way to create the payoff of a financial instrument using other financial instruments.
A synthetic position can be created by buying or selling physical financial instruments and/or derivatives.
If you buy several instruments which have the same payoff
as investing in a share, you have a synthetic underlying position. In a similar way, a synthetic option position can be created.
For example, a position which is long (a 60-strike call) and short (a 60-strike put) will always result in purchasing the underlying asset for 60 at exercise or expiration. If the underlying asset is above 60, the call is in the money and will be exercised; if the underlying asset is below 60 then the short put position will be assigned, resulting in a (forced) purchase of the underlying at 60.
Another example is that of a naked put option, which has the same profit/loss potential of a covered call (where an investor is long in the stock and short in the call option).
One advantage of a synthetic position over buying or shorting the underlying stock is: there is no need to borrow the stock if you are short selling it. Another advantage is that we don't have to worry about dividend payments on the short stock.(if any, declared by the Underlying Security.)
When the underlying asset is a stock, a synthetic underlying position is sometimes called a synthetic stock.
dollars in your bank account.
(Here
is the strike price
of the option, and
is the continuously compounded interest rate, 
is the time to expiration and 
is the spot price of the stock at option expiration.)
At expiry you have to repay the stock, which gives a cashflow
. The bank account will give a cashflow of 
dollars. Moreover, the European call gives a cashflow of 
. The total cashflow is 
. We see that the total cashflow at expiry is exactly the cashflow of a European put option.
Finance
"Finance" is often defined simply as the management of money or “funds” management Modern finance, however, is a family of business activity that includes the origination, marketing, and management of cash and money surrogates through a variety of capital accounts, instruments, and markets created...
, a synthetic position is a way to create the payoff of a financial instrument using other financial instruments.
A synthetic position can be created by buying or selling physical financial instruments and/or derivatives.
If you buy several instruments which have the same payoff
Payoff
Payoff may refer to:* Bribery* A payoff dominant equilibrium in game theory* Payoff matrix or payoff function in a normal form game in game theory* Payoff set in set theory* Payoff, a 1991 TV film starring Keith Carradine...
as investing in a share, you have a synthetic underlying position. In a similar way, a synthetic option position can be created.
For example, a position which is long (a 60-strike call) and short (a 60-strike put) will always result in purchasing the underlying asset for 60 at exercise or expiration. If the underlying asset is above 60, the call is in the money and will be exercised; if the underlying asset is below 60 then the short put position will be assigned, resulting in a (forced) purchase of the underlying at 60.
Another example is that of a naked put option, which has the same profit/loss potential of a covered call (where an investor is long in the stock and short in the call option).
One advantage of a synthetic position over buying or shorting the underlying stock is: there is no need to borrow the stock if you are short selling it. Another advantage is that we don't have to worry about dividend payments on the short stock.(if any, declared by the Underlying Security.)
When the underlying asset is a stock, a synthetic underlying position is sometimes called a synthetic stock.
Synthetic long put
The synthetic long put position consists of three elements: shorting one stock, holding one European call option and holding dollars in your bank account.(Here
is the strike priceStrike price
In options, the strike price is a key variable in a derivatives contract between two parties. Where the contract requires delivery of the underlying instrument, the trade will be at the strike price, regardless of the spot price of the underlying instrument at that time.Formally, the strike...
of the option, and
is the continuously compounded interest rate, is the time to expiration and is the spot price of the stock at option expiration.)At expiry you have to repay the stock, which gives a cashflow
. The bank account will give a cashflow of dollars. Moreover, the European call gives a cashflow of . The total cashflow is . We see that the total cashflow at expiry is exactly the cashflow of a European put option.