The global futures and options market has grown considerably over the last 50 years and, in many cases, created situations where the "tail is wagging the dog". The power and influence of these markets are enormous, and while often accused of fuelling speculation, there are ways in which you can use these instruments to protect your portfolio.
What are synthetic investment positions?
In a similar fashion to the term synthetic materials, artificial, synthetic investment positions mimic "normal" investment strategies, but they are structured using options, futures and similar investment instruments. They can be as complex or straightforward as you require, using leverage and different degrees of risk to mimic the payoff of a traditional investment strategy.
Different types of synthetic positions
The simplest forms of synthetic positions are:-
Synthetic longs
This involves purchasing a long call and the sale of a short put to mimic the scenario of owning an actual stock. In this situation, the sale of the short put creates income, a premium, which will partially finance the long call.
Synthetic shorts
On the flip side, a synthetic short would see the purchase of a long put and the sale of a short call. The sale of the short call would create income to partially fund the long put as the investor is effectively doubling up on their expectations that the stock will fall.
When looking at synthetic longs and shorts, the strike price and the expiration date for the calls and puts would be the same.
Pros of synthetic investment positions
As with any investment strategy, there are pros and cons to consider before committing your funds. The significant benefits of a synthetic investment position include:-
· Cost efficiency – based on options and futures premiums, this is less capital intensive than purchasing actual assets, helping cash flow.
· Flexibility – we have shown the basic synthetic longs and shorts above; using futures, options, and different strike prices and periods allows you to mimic any investment strategy.
· Access to unavailable assets – while it is essential to trade your synthetic positions on recognised and protected stock exchanges, there may be opportunities to access previously unavailable assets. This can help with investment returns and diversification.
· Hedging – using actual stock positions, similar to going long and short of options, synthetic positions can be created to protect portfolios and hedge against unwelcome market movements.
Cons of synthetic positions
When looking at mimicking traditional investment strategies, using synthetic investment instruments, it is crucial to appreciate the pros and cons. The potential downside to synthetic positions includes:-
· Complexity – you can make these positions as simple or complex as you like. However, the more complex positions require a greater understanding of financial markets and instruments.
· Leverage – leverage is great when the stock is going your way, but if it goes against you, there may be significant downside.
· Counterparty risk – this is negligible when dealing with recognised and regulated investment markets, although there is a greater risk when dealing off-market on unregulated platforms.
· Regulations and taxation – there may be different tax treatments compared to traditional investments, which could also differ between countries.
Different types of synthetic investment positions
Aside from the traditional synthetic long stock and synthetic short stock positions, there are other common strategies:-
· Synthetic long call
· Synthetic short call
· Synthetic long put
· Synthetic short put
· Synthetic call spread
· Synthetic put spread
· Synthetic straddle
· Synthetic strangle
· Synthetic futures
· Synthetic covered call
· Synthetic protective put
While similar to investment strategies available with straightforward call and put options, you can use options, futures, and any other derivative when it comes to synthetic spreads.
Conclusion
On the surface, synthetic investment positions are relatively simple. However, once you begin to dig a little deeper, looking at the different products you can use, and assets you can create exposure to; they can become very complex. We only need to look at the US subprime mortgage crash in 2007/8 to see how the splicing and dicing of mortgage loan capital and interest repayments, used to create a range of synthetic income bonds, can come crashing down in the wrong situation