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Long Synthetic (Synthetic Put)

Definition

A long synthetic, also known as a synthetic put, is a financial trading strategy that involves buying a call option and selling a similar quantity of underlying assets. This strategy is used to mimic the return and risk profile of a put option without actually owning it. It provides traders with a way to speculate on downward price movements for an underlying asset.

Phonetic

The phonetics of the keyword “Long Synthetic (Synthetic Put)” would be:Long: lɔːŋ Synthetic: sɪnˈθɛtɪk Synthetic Put: sɪnˈθɛtɪk pʊt

Key Takeaways

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  1. A Long Synthetic or a Synthetic Put is an options strategy that involves a bull call spread and a bear put spread. It’s designed to mimic the profit and loss potential of a short stock position without the significant capital outlay.
  2. Long synthetics can be appropriate when an investor expects a substantial price change in the underlying stock on a particular event. It benefits from increased volatility and requires an accurate prediction of the direction of stock price change.
  3. The risk/reward profile of long synthetic is the opposite of a short sale. If the underlying stock rises, the investor loses, but if the stock falls, the investor can gain. The maximum possible loss is typically the strike price of the put option.

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Importance

The business/finance term, Long Synthetic, also known as Synthetic Put, is important as it involves an investing strategy that artificially replicates the risk-reward properties of owning a put option while using a combination of other financial instruments. This strategy provides investors with the opportunity to gain exposure to a specific asset’s price movements without actually owning the asset itself. It is commonly used for hedging purposes, to limit potential losses, or to speculate on price movements in an anticipative manner. By using options and debts to mimic the underlying asset, investors can potentially enjoy the same returns as if they had directly invested in the asset. Synthetic puts, therefore, offer a degree of flexibility that may not be available with direct investment in the underlying asset. Additionally, synthetic puts can be less expensive than a direct investment, freeing up capital for other investments.

Explanation

The Long Synthetic, often referred to as a Synthetic Put, is an investment strategy primarily used in options trading, the purpose being to mirror the payoff of a long put option by simultaneously buying a call option and selling a corresponding number of shares of the underlying stock. This is commonly used by traders who believe the price of the underlying asset will decrease, but do not currently own the asset or would prefer not to sell it short. The Synthetic Put allows traders to profit from a decrease in the asset’s price with limited risk, as their loss is only the premium paid for the call option.Its main use lies in offering the trader the ability to gain exposure to the price movements of an underlying asset without actually owning the asset. This is especially beneficial in situations of high asset prices or when the trader wants to avoid additional costs, like transaction fees. Secondly, it is also used as a protective strategy, allowing the trader to hedge against potential price drops of an underlying asset they already own. Thus, the Synthetic Put acts as a type of insurance, offering downside protection and limiting potential losses.

Examples

1. Tech Company: Suppose an investor has a bullish outlook on Tech Company X, predicting its stock will rise significantly over the next year. However, the investor does not presently have enough funds to buy substantive shares. The investor can create a long synthetic position for Company X’s stocks by purchasing a call option and selling a put option at the same strike price and expiry date. This allows the investor to gain upside exposure to the stock without buying it outright.2. Agricultural Industry: A commodity trader predicts that the future price of wheat will increase due to favorable weather conditions. But, the trader doesn’t want to hold physical wheat due to storage costs. They can construct a synthetic long position through options contracts (buy a call and sell a put on wheat futures), benefiting from the price increase without dealing with physical inventory.3. eCommerce Company: Let’s say an investor forecasts a successful holiday season for an eCommerce company Y due to increased online shopping trends. Instead of buying the company’s high-priced stock, the investor can replicate the long position using a long synthetic (buy a call option and sell a put option with the same strike price and expiry). This strategy can mimic owning the company’s stock and allows the investor to benefit from the anticipated stock price increase.

Frequently Asked Questions(FAQ)

What is Long Synthetic or Synthetic Put in finance?

Long Synthetic, also known as Synthetic Put, is a trading strategy that mimics the payoff of a long put option. It is created by being long (buying) an at-the-money call option and shorting (selling) the underlying stock.

How is a Long Synthetic constructed?

A Long Synthetic is constructed by buying at-the-money call options and short (or selling) an equal amount of the underlying shares of stock. This combination mimics the behavior of a long put option.

Why and when would an investor use a Long Synthetic strategy?

A Long Synthetic is used when an investor anticipates a decrease in the stock’s price but prefers not to directly short the stock. This strategy is used when one wants to hedge against potential losses from stock ownership.

What are the risks involved in a Long Synthetic strategy?

The primary risk in a Long Synthetic strategy includes a potential loss if the price of the underlying stock increases. The maximum loss of a long synthetic position is limited to the strike price of the at-the-money call option, less the net debits incurred in establishing the position.

Is a Long Synthetic the same as a Synthetic Long?

No, a Long Synthetic and a Synthetic Long are different. A Long Synthetic imitates the payoff of a long put option. In contrast, a Synthetic Long imitates the payoff of a long stock position.

How does Long Synthetic differ from directly buying a put option?

While a Long Synthetic mimics the payoff of a long put option, it differs in mindsets relating to premium, volatility, and time decay. When buying a put option, an investor pays a premium and is subject to time decay of the option contract. A Long Synthetic seeks to neutralize the impact of time decay and reduce the cost of the option premium.

What is the payoff of a Long Synthetic?

The payoff of a Long Synthetic is identical to a long position in a put option. Hence, if the underlying stock’s price declines, the investor will gain, and if the price increases, the investor will suffer a loss.

Are there specific requirements or qualifications needed to create a Long Synthetic option?

Yes, most brokers require an approval level for options trading due to the increased risk they hold. An investor must make an application and confirmation of the necessary financial resources and trading experience to get approval.

Related Finance Terms

  • Options Contract: The agreement between two parties to conduct a transaction on a security, which can be either a call (buy) or put (sell) option.
  • Derivative Security: Financial tools such as options or futures whose value is derived from some other asset, such as stocks or currency.
  • Straddle Strategy: A strategy used in trading options, which includes the simultaneous purchase of a put and a call option, with the same strike price and expiration date.
  • Underlying Asset: The financial instrument (like stock, futures, commodity, currency, index) upon which a derivative’s price is based. It is these assets that give derivatives their value.
  • Hedging: A strategy to reduce risk by undertaking an investment activity to offset potential losses/gains in the value of an asset.

Sources for More Information

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