There is a constant push for portfolio diversification into alternative investments, such as futures and commodities, but oftentimes it is difficult to make the leap. That's where the concept of synthetic futures comes in. For those looking to avoid a huge initial investment and manageable risk, synthetic futures provide an opportunity to help you ease into portfolio diversification without betting the farm.

An Influential Study
In 2004, a brief but powerful white paper was put out by the YaleInternationalCenter for Finance. The paper was entitled "The Facts and Fantasies about Commodity Futures". In the paper, the authors set out to answer two questions

  1. Are commodity futures riskier than stocks?
  2. Can commodity futures provide diversification to other asset classes?

The answer to the first question was a resounding "no". The study revealed that more than 45 commodity futures were not only comparable to the S&P 500, but they also consistently outperformed corporate bonds. In fact, both the S&P 500 and commodity futures shared an average return of 11.02%. When the standard deviation was taken into account, the S&P 500 returns came out slightly higher, at 14.9%, and commodity futures moved up to 12.12%.

The answer to the second question was a resounding "yes". In order to best determine whether commodity futures and the S&P 500 were correlative or not, the white paper examined three different time intervals: every quarter, every year and every five years. Their research revealed that the best benefit of commodity futures was the fact that they negatively correlate with different asset classes, and as time goes on, the negative correlation steadily increases. This was a significant discovery. (For more, see Futures Fundamentals.)

In the months in which equity markets performed worst, commodity futures actually gained in value. The Yale study found that during some of their worst months (the lowest 1% of months in terms of performance of equity markets), stocks fell an average of 13.87% while commodities returned an average 2.32%. When the stocks fell an average of 9.18% (during the lowest 5% of months in terms of performance of equity markets), commodities were returning 1.43%.

Time To Consider Synthetic Futures
Even though there is a clear argument for investors to diversify into alternative investments, the fear - whether irrational or rational - of venturing out into futures is difficult for the majority of investors to overcome. In fact, the futures industry itself doesn't encourage investors to make the leap. The risk disclosure states that you may lose your entire investment and more when you invest in futures. This is far from encouraging.

The alternative is to invest in options on futures, but they have their own problems. While options have the ability to limit your risk to the amount you invest, they are difficult to pick. You have to decide if you are going to purchase an option "out of the money", "at the money" or "in the money". While deciding that, you also have to determine which one closely follows the underlying futures. In addition, the closer you want your option to be to the current futures price at the money or in the money, the more you will have to pay. The additional costs can be attributed solely to the amount of volatility affecting the contract at the time. (For more insight, read Becoming Fluent In Options On Futures.)

When futures seem scary because you can lose more than you expected, and the options that are the most likely to succeed are prohibitively expensive, investors can turn to the alternative: synthetic futures. They combine the best of both worlds - they allow you to follow the underlying futures as closely as possible to turn a profit, they help reduce the amount you have to spend on an in-the-money option, and they have the ability to minimize your risk when used properly.

Types of Synthetic Futures
There are two types of synthetic futures, a synthetic long and a synthetic short.

A synthetic long entails two transactions: purchasing an at-the-money call option, and selling an at-the-money put. For example, if the gold market was at $960 and you felt that it was going to $1,000, to trade the futures outright you would have to put $4,725 in margin (common margin requirement). The options on this same contract are a lot less. For example, an at-the-money $960 call is priced at $2,710, and an at-the-money put is priced at $2,500.

By purchasing the call outright, you immediately benefit from a $2,015 savings over having to put in $4,725 for the futures margin. A synthetic long is created by taking the process one step further - selling the at-the-money put for $2,500. This brings your total cost for the call down from $2,710 to $210 (the amount paid, minus the collected premium: $2,710 - $2,500 = $210 spent). So, while putting on the outright futures would have cost you $4,725 up front, the same position as a synthetic long would cost you only $210. That's a savings of $4,515.

A synthetic short is just the opposite - you purchase an at-the-money put and sell an at-the-money call. Let's take the same gold example. The market is at $960 and you decide to purchase an at-the-money $960 put for $2,500. By purchasing the put outright you have a savings of $2,225 over the futures. By taking the process one step further and selling an at-the-money call for $2,710, you turn your position into a synthetic short. This actually makes the put you bought cost nothing, and adds an additional $210 to your account (the amount paid, minus the collected premium: $2,500 - $2,710 = $210 profit).

Pros and Cons
So, if you decide to take advantage of a synthetic long position it would cost you only $210, and if you decide to take advantage of a synthetic put position it would cost nothing. This is a big difference from the required $4,725 you would have to have as margin if you decided to trade a futures contract by itself.

With synthetic futures as with everything else, there is still plenty of opportunity for loss. While it may cost less to place the position, you are still exposed to the same unlimited loss that's typical of an outright futures position. The question you have to ask yourself is whether it's more feasible to risk a few hundred dollars on the position or put up several thousand. Depending on your answer, the tools you would use to protect yourself from losing it all in a futures position are the same tools you would use in a synthetic futures position: stop-loss orders, limit orders and protective options. There are subtle and few differences in their execution. (To learn more, red Money Management Matters In Futures Trading.)

Conclusion
While there is constant pressure to diversify your portfolio with commodity futures from magazines, white papers and newspapers, it only makes sense to do so if you can afford the risk capital and feel comfortable with the amount you are risking. For those unable or unwilling to trade commodity futures outright, synthetic futures can provide just that type of opportunity.

Related Articles
  1. Options & Futures

    What Does Quadruple Witching Mean?

    In a financial context, quadruple witching refers to the day on which contracts for stock index futures, index options, and single stock futures expire.
  2. Investing Basics

    10 Habits Of Successful Real Estate Investors

    Enjoying long-term success in real estate investing requires certain habits. Here are 10 that effective real estate investors share.
  3. Investing Basics

    5 Types of REITs And How To Invest In Them

    Real estate investment trusts are historically one of the best-performing asset classes around. There are many types of REITs available.
  4. Investing Basics

    5 Simple Ways To Invest In Real Estate

    There are many ways to invest in real estate. Here are five of the most popular.
  5. Options & Futures

    4 Equity Derivatives And How They Work

    Equity derivatives offer retail investors opportunities to benefit from an underlying security without owning the security itself.
  6. Stock Analysis

    Analyzing Altria's Return on Equity (ROE) (MO)

    Learn about Altria Group's return on equity (ROE) and analyze net profit margin, asset turnover and financial leverage to determine what is causing its high ROE.
  7. Options & Futures

    Five Advantages of Futures Over Options

    Futures have a number of advantages over options such as fixed upfront trading costs, lack of time decay and liquidity.
  8. Retirement

    Dollar Shave Club Review: Is It Worth It?

    Learn about the business model of the Dollar Shave Club, and find out whether the razor subscription company is a worthwhile investment.
  9. Term

    The Implications of Nonfarm Payroll

    The nonfarm payroll is a key economic indicator that’s closely monitored by analysts and investors around the world.
  10. Stock Analysis

    Analyzing Boeing’s Return on Equity (ROE) (BA)

    Learn about Boeing's return on equity and find out how the company's ROE compares to its own historical performance and aerospace industry peers.
RELATED FAQS
  1. What is a derivative?

    A derivative is a contract between two or more parties whose value is based on an agreed-upon underlying financial asset, ... Read Full Answer >>
  2. What is after-hours trading? Am I able to trade at this time?

    After-hours trading (AHT) refers to the buying and selling of securities on major exchanges outside of specified regular ... Read Full Answer >>
  3. What is securitization?

    Securitization is the process of taking an illiquid asset, or group of assets, and through financial engineering, transforming ... Read Full Answer >>
  4. Can hedge funds trade penny stocks?

    Hedge funds can trade penny stocks. In fact, hedge funds can trade in just about any type of security, including medium- ... Read Full Answer >>
  5. Do hedge funds invest in commodities?

    There are several hedge funds that invest in commodities. Many hedge funds have broad macroeconomic strategies and invest ... Read Full Answer >>
  6. Can hedge funds outperform the market?

    Generating returns that exceed those provided by the broader market is the goal of nearly every investor. However, the methods ... Read Full Answer >>
Hot Definitions
  1. Super Bowl Indicator

    An indicator based on the belief that a Super Bowl win for a team from the old AFL (AFC division) foretells a decline in ...
  2. Flight To Quality

    The action of investors moving their capital away from riskier investments to the safest possible investment vehicles. This ...
  3. Discouraged Worker

    A person who is eligible for employment and is able to work, but is currently unemployed and has not attempted to find employment ...
  4. Ponzimonium

    After Bernard Madoff's $65 billion Ponzi scheme was revealed, many new (smaller-scale) Ponzi schemers became exposed. Ponzimonium ...
  5. Quarterly Earnings Report

    A quarterly filing made by public companies to report their performance. Included in earnings reports are items such as net ...
Trading Center