What is a Synthetic Forward Contract
A synthetic forward contract, or synthetic long forward contract, is a position in which the investor buys a call option and sells a put option at the same time. Both options must have the same strike price and expiration date
Its purpose is to mimic a regular forward contract, and is also called a synthetic futures contract. The investor will typically pay a net option premium when executing a synthetic forward contract as not all the premium paid for the long position is offset by sale of the short position.
For a synthetic short forward contract, the investor buys a put and sells a call, again with the same strike price and expiration date.
BREAKING DOWN Synthetic Forward Contract
Synthetic forward contracts can help investors reduce their risk, although as with trading futures outright, investors still face the possibility of significant losses if they don't implement proper risk management strategies. A major advantage of synthetic forwards is that a "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.
How the Trade Works
For example, to create a synthetic long forward contract on a stock, buy a call with a $60 strike price. And at the same time, sell a put with a $60 strike price and same expiration date. At expiration, the investor will buy the underlying asset by paying the strike price.
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 owner of the put that was sold 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 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.