This is REQUIRED knowledge for anyone who is thinking about or actively involved in trading futures. Not another trade should ever be placed unless you have a complete understanding of how to use options to create synthetic futures.
What is a Synthetic Future position?
It is the strategy of buying and selling options that allow you to emulate outright futures contracts.
Why would I want to emulate a futures contract using options?
For some serious account protection in the event that you caught in a market that is making limit moves against your position, and there is no trading allowing you to get out.
If you have been trading futures for any real length of time, it is likely that you have at one time or another been in a trade at the time the market goes limit up or down. Perhaps you were fortunate to be on the correct side of the move, or perhaps you had the unfortunate experience of being on the wrong side.
Being on the wrong side of a limit move can really do some serious damage to your mental well-being. The feeling of being 'trapped' comes to mind. However, this feeling need not ever happen to you as long as you understand how options can help you turn off the mounting of additional losses.
Back in 1993, the lumber market found itself trading limit up for several days. Traders that were short lumber futures at that time were unable to buy back their contracts in order to exit the market. Those that were not familiar with using options to create synthetic futures positions suffered devastating losses. Each contract accumulated losses totaling nearly $9000 until some very limited trading occurred. If the short trader was unable to offset his position at that time, the trader was then stuck for more limit up moves that eventually totaled about $25,000 per contract!
However, those traders that understood how to use options as synthetic futures positions were able to stop the bleeding the very first limit up day. By using options to create a synthetic long futures position, this offset the short position effectively removing the trader from any additional losses.
How do you create a Synthetic futures position?
If you want to create a synthetic long position, you would Buy an ATM (at-the-money) CALL and Sell an ATM PUT at the same strike price. If you want to create a synthetic short position, you would Buy an ATM PUT and Sell an ATM CALL at the same strike.
Why not just purchase the option rather than selling one also?
This question has been asked of me in the past. If the market was limit up and you were short, why not just buy a CALL option in the event prices continued limit up the next day or so? The answer is simple: A larger than necessary loss.
With the example just outlined, while buying the CALL would protect you against additional losses if the market were to continue limit up, it would be very expensive and the cost would be added to what you have already lost due to the limit move. By selling a PUT at the same strike, the premium you collect will offset the premium you paid for the CALL. There may be a slight difference in price between the two options due to the increased volatility, but if you create the synthetic at the time of the first limit move, it will be much more manageable than if you wait and suffer additional limit moves against you. The spread in premium between the two options will of course be added to your overall losses, but you will then have effectively offset your position from any further losses.
How does it work?
So say you are short futures and the market goes limit up. The price is currently 350 in Soybeans. You Buy a 350 CALL @ $900 and Sell a 350 PUT @ $825. The cost of the synthetic to you is $75 in this case. Your short futures is now offset by the synthetic long option position. If price continued higher, the CALL would cover it. If prices stopped moving limit up and actually moved down, the short futures would cover the short PUT option. Therefore, you have effectively offset your position at 351.50 (the additional 1.50 covers the $75 cost of the option spread).
Before you trade futures, or continue to do so, be sure you understand how synthetic future positions are created using options. Also, if you find yourself on the wrong side of a limit move, do not hesitate to put on the position. The longer you wait, you more you may end up paying for the premium spread.
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