What is a Synthetic Futures Contract?
- A synthetic futures contract uses put and call options with the same strike price and expiration date to simulate a traditional futures contract.
- Synthetic futures contracts can help investors reduce their risk.
- A major advantage of a synthetic futures contract is that a "future" 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.
Understanding Synthetic Futures Contracts
The purpose of a synthetic futures contract, also called a synthetic forward contract, is to mimic a regular futures contract. The investor will typically pay a net option premium when executing a synthetic futures contract as the premium paid is, usually, not offset by the premium collected.
There are two types of traditional futures contracts that can be replicated by synthetic futures contracts:
- Long futures position: Buy calls and sell puts with the identical strike price and expiration date.
- Short futures position: Buy puts and sell calls with the identical strike price and expiration date.
Synthetic futures 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. Another major advantage of a synthetic futures contract is that a "future" 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.
Synthetic Long Futures Contract
To create a synthetic long futures 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, no matter which way the market moves before that time.
- 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 futures 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.