What Is Synthetic Forward Contract?
A synthetic forward contract uses call and put options with the same strike price and time to expiry to create an offsetting forward position. An investor can buy/sell a call option and sell/buy a put option with the same strike price and expiration date with the intent being to mimic a regular forward contract. Synthetic forward contracts are also called synthetic futures contracts.
- A synthetic forward contract uses call and put options with the same strike price and time to expiry to create an offsetting forward position.
- Synthetic forward contracts can help investors reduce their risk.
- A synthetic forward contract requires that the investor pay a net option premium when executing the contract.
Understanding Synthetic Forward Contracts
Synthetic forward contracts can help investors reduce their risk although, as with trading futures outright, investors still face the possibility of significant losses if proper risk management strategies are not implemented. For instance, a market maker can offset the risk of holding a long or short forward position by creating a corresponding short or long synthetic forward position.
A major advantage of synthetic forwards is that a regular forward position can be maintained without the same types of requirements for counterparties, including the risk that one of the parties will renege on the agreement. However, unlike a forward contract, a synthetic forward contract requires that the investor pay a net option premium when executing the contract.
For example, to create a synthetic long forward contract on a stock (ABC stock at $60 for June 30, 2019):
- An investor buys a call with a $60 strike price with expiry on June 30, 2019.
- An investor sells (writes) a put with a $60 strike price with expiry on June 30, 2019.
- If the stock price is above the strike price on the expiration date, the investor, who owns the call, will want to exercise that option and pay the strike price to buy the stock.
- If the stock price at expiration is below the strike price, the buyer of the put will want to exercise that option. The result is the investor will also buy the stock by paying the strike price.
In either case, the investor ends up buying the stock at the strike price, which was locked in when the synthetic forward contract was established.
Keep in mind that there could be a cost for this guarantee. It all depends on the strike price and expiration date chosen. Put and call options with the same strike and expiration may be priced differently, depending on how far in the money or out of the money the strike prices may be. Typically, the parameters chosen end up with the call premium being slightly higher than the put premium, creating a net debit in the account at the start.