Synthetic long and short positions, along with conversions and reversals, are advanced options trading strategies used to replicate the payoff profiles of underlying assets, either for speculation or hedging purposes. These strategies involve combinations of options and sometimes the underlying asset itself. Let’s explore each of these strategies in detail:
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Synthetic Long Position:
A synthetic long position is a trading strategy that replicates the payoffs of owning an underlying asset, such as a stock, without actually purchasing the asset. It involves a combination of options to create a position that behaves like owning the asset.
Components of a Synthetic Long Position:
- Long Call Option: An investor buys a call option. This gives them the right to buy the underlying asset at a specified strike price before or at the option’s expiration date.
- Short Put Option: Simultaneously, the investor sells a put option. This obligates them to buy the underlying asset at the same specified strike price if the option is exercised by the put holder.
Purpose of a Synthetic Long Position:
A synthetic long position is used when an investor wants to gain exposure to the potential price appreciation of an underlying asset, but may not want to invest the capital required to buy the asset outright. It provides leverage and allows for profit from upward price movements.
Payoff Profile of a Synthetic Long Position:
- Profit: The profit potential is unlimited as the price of the underlying asset increases. This is similar to owning the asset.
- Loss: The loss is limited to the combined premiums paid for the call option and received for the put option.
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Synthetic Short Position:
A synthetic short position is a trading strategy that replicates the payoffs of selling an underlying asset without actually selling the asset. This is useful for investors who believe the price of an asset will decrease.
Components of a Synthetic Short Position:
- Short Call Option: An investor sells a call option. This obligates them to potentially sell the underlying asset at a specified strike price if the option is exercised by the call holder.
- Long Put Option: Simultaneously, the investor buys a put option. This gives them the right to sell the underlying asset at the same specified strike price before or at the option’s expiration date.
Purpose of a Synthetic Short Position:
A synthetic short position is used when an investor wants to profit from a potential decline in the price of an underlying asset, but may not want to short sell the asset directly. It provides a way to benefit from downward price movements.
Payoff Profile of a Synthetic Short Position:
- Profit: The profit potential is unlimited as the price of the underlying asset decreases. This is similar to short selling the asset.
- Loss: The loss is limited to the combined premiums paid for the put option and received for the call option.
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Conversions:
A conversion is an arbitrage strategy that aims to exploit price discrepancies between options and the underlying asset. It involves buying the underlying asset, buying a put option, and selling a call option, all with the same strike price and expiration date.
Components of a Conversion:
- Buy Underlying Asset: The investor purchases the underlying asset.
- Buy Put Option: Simultaneously, they buy a put option with the same strike price and expiration date.
- Sell Call Option: They also sell a call option with the same strike price and expiration date.
Purpose of a Conversion:
The goal of a conversion is to take advantage of any mispricing between the options and the underlying asset. It is a risk-free strategy if executed correctly, as it ensures a profit regardless of the price movement of the underlying asset.
Payoff Profile of a Conversion:
- Profit: The profit from a conversion is guaranteed and arises from the price discrepancy between the options and the underlying asset. It is equal to the difference between the call premium received and the put premium paid.
- Loss: There is no loss potential in a correctly executed conversion.
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Reversals:
A reversal is another arbitrage strategy that seeks to exploit price discrepancies between options and the underlying asset. It involves selling the underlying asset, selling a put option, and buying a call option, all with the same strike price and expiration date.
Components of a Reversal:
- Sell Underlying Asset: The investor sells the underlying asset short.
- Sell Put Option: Simultaneously, they sell a put option with the same strike price and expiration date.
- Buy Call Option: They also buy a call option with the same strike price and expiration date.
Purpose of a Reversal:
Like a conversion, the goal of a reversal is to capitalize on any mispricing between the options and the underlying asset. It is also a risk-free strategy if executed correctly.
Payoff Profile of a Reversal:
- Profit:
The profit from a reversal is guaranteed and arises from the price discrepancy between the options and the underlying asset. It is equal to the difference between the put premium received and the call premium paid.
- Loss:
There is no loss potential in a correctly executed reversal.
Considerations and Risks:
- Execution and Timing:
Both conversions and reversals require precise execution and must be timed accurately to capitalize on any mispricing.
- Market Efficiency:
These strategies rely on the assumption that markets are not perfectly efficient. Any mispricing is quickly corrected in efficient markets, making these opportunities rare.
- Arbitrageurs:
Professional traders and market makers often look for these opportunities and quickly exploit them, reducing the potential profits for individual investors.