What Is Synthetic Trading?

In this article, we will discuss

• What Is a Synthetic Trading Strategy?
• Synthetic Trading in Futures and Options
• Synthetic Trading: Advantages and Disadvantages
• Why Choose Samco for F&O Trading?
• Final Words
• Frequently Asked Questions

Synthetic trading has been around for a while, but not many investors have been using it actively. It is a clever way for traders to enjoy the benefits of investing in financial assets without putting in the full amount of money upfront. It's like finding creative shortcuts to mimic real trades without spending as much. But like all trading strategies, it has risks, and it requires knowledge and practice to do it right.

Here in this article, you will get to know about what is synthetic trading strategy, how it is applied to derivative instruments like futures and options, its pros and cons and much more.

What Is a Synthetic Trading Strategy?

It is a strategic approach that helps to reap benefits from investing in a financial instrument without committing to a full and direct investment. This strategy involves tailoring transactions to mimic the outcomes of real transactions by adjusting variables such as expiry dates, cash flow, etc.

This type of trading utilises synthetic instruments, which are a type of financial asset designed to mimic other financial assets. A synthetic position results in the same payout as another financial instrument while having different characteristics.

Here’s an example of synthetic trading. Let’s say you buy shares of XYZ at ₹1,000; this creates an original position using a financial asset. But what if instead of buying shares, you buy a call option and sell a put option simultaneously at a strike price of ₹1,000? Now, you have created a synthetic position whose effects are the same as buying the stock.

Synthetic Trading in Futures and Options

As we all know, the dynamic nature of the stock market means that stock prices fluctuate from time to time. In order to balance out such risks, traders use synthetic trading strategies, which can also be used on any other instruments.

Futures and options are one of the most popular synthetic derivatives examples. Traders often use them together to get the same results they would from a futures or an options contract by entering multiple options contracts.

One of the key differences between a futures contract and an options contract is how they deal with mark-to-market practices and margin money. As both futures and options are exercised on the expiry date, the holder has to keep a marginal amount deposited to keep it active until expiry.

The margin changes every day until the contract ends. With options, there's no need for cash settlements, but premiums have to be paid to the options seller. With futures, traders have to settle the margin cash every day. This can add up to a lot of cash expenses.

To avoid these expenses and maintain cash in hand, traders often choose synthetic futures trading instead of regular futures contracts. The payoff for synthetic and regular futures looks the same.

Synthetic Trading: Advantages and Disadvantages

Usually, experienced traders prefer synthetic trading over regular trading because it helps them save money and offers liquidity. As these traders understand the time value of money i.e. money now is worth more than money later, they use this synthetic trading to have cash on hand to use elsewhere.

Furthermore, you can make extra money from option premiums by holding the position of an option seller with synthetic trading.

However, trading always carries risks, and they vary depending on the type of trading. Big and unexpected changes in prices can hurt synthetic trading. Also, coming up with synthetic trading strategies can be a bit complex. To reliably make profits, you have to possess enough knowledge, be skilled and have experience in the field. If you get it wrong, you might lose money instead of making it.

Why Choose Samco for F&O Trading?

If you're ready to start with F&O trading, consider registering with the Samco Trading App. It offers a tidy and feature-rich trading interface, ensuring a seamless trading experience. Furthermore, you can track the performance of your trades and compare it against a benchmark for continuous self-improvement.

With the Upgraded TradingView, you will have access to over 16 types of charts and 50+ technical indicators. You will also get live options greeks and IV charts on the Samco Trading App for an enhanced trading experience.

Final Words

Synthetic trading is a strategy that allows traders to enjoy the benefits of investing in financial instruments without making a full investment. It's like finding clever ways to mimic the outcomes of real trades without spending much money upfront. While it can be a useful tool, at the same time it's important to remember that trading always involves risks. Hence, understanding how to use synthetic trading effectively requires knowledge, skill, and practice.

Frequently Asked Questions

1. Is synthetic trading profitable?

Ans. As the stock market is highly volatile in nature, stock prices can fluctuate considerably from time to time which can lead to both large profits and losses. Similarly, leveraging such underlying securities through derivative contracts can also amplify the gains just like it can also magnify losses.

2. Why buy synthetic stock?

Ans. A synthetic call or put acts like a regular call or put option, offering the chance for unlimited profit and limited loss, but without needing to choose a specific strike price. Also, synthetic positions help control the risk that comes with cash or futures trading, which can be unlimited if not managed properly.

3. What are the disadvantages of synthetic options?

Ans. The downside of Synthetic options can be when the market goes against a cash or futures position, it means losing money right away. But with a protective option, it's supposed to gain value at the same rate, helping to offset those losses.

4. How many types of synthetic option strategies are there?

Ans. There are a total of six types of synthetic options which include: Synthetic Long Stock, Synthetic Short Stock, Synthetic Long Call, Synthetic Short Call, Synthetic Long Put and Synthetic Short Put.

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