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What is a Synthetic Option?

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  • Written By: Malcolm Tatum
  • Edited By: Bronwyn Harris
  • Last Modified Date: 09 September 2016
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    2003-2016
    Conjecture Corporation
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The synthetic option is a product that can be used to help control and minimize losses to a company which sometimes occur due to a change in interest rates or the exchange rate of currency. At the same time, the option does maintain some potential for realizing a gain as well as acting as a controlling agent.

A synthetic option functions by utilizing a mixture of various futures and standard options to come up with an option profile that will create the desired effect. One basic example of employing a synthetic option would be to purchase futures along with buying a number of puts. This more or less will achieve the same end as buying a call, but has the potential to lock in a margin on the purchase as well.

Essentially what occurs with a synthetic option is that the process of creating this type of option artificially creates a condition that mirrors a payoff of an underlying transaction or position that has a long call and a short put that have the same expiration and strike. Making sure the long call and the short put are always at the same strike will maintain the strike at the time of exercise or expiration, so there is no chance of a loss. At the same time, this process also does not limit the chance for realizing an increase on the transaction.

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One of the advantages to employing a synthetic option is that there is always the chance to make some changes as you go along. For example, if market circumstances make it advantageous, the option could be structured with a slightly lower strike put and a slightly higher strike call. This would be a good way to progress if there is some trading taking place that falls in between the strike put and the strike call. The investor is then covering an acceptable range and can maneuver easier to meet whatever conditions may come into play regarding the stock. Also, this will help to ensure that the investor does not lose money even if the stock price falls slightly. As long as the stock price is above the lower strike put, the investment remains sound and does not decrease in value.

Use of the synthetic option is not for the novice. Understanding when and how to apply it in investing requires a sound and competent knowledge of the way that the stock markets work. For this reason, the strategy of a synthetic option is best undertaken only by those who have been trading for some time and know the market well, or only at the advice of a professional investment advisor.

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