A synthetic position is a trading strategy that uses a combination of multiple financial instruments to replicate the exact cash flow and risk profile of a different, single asset.
Mechanics of synthetic positions
Traders create synthetic positions when they want exposure to a specific asset but prefer not to buy or sell that underlying asset directly. This strategy relies heavily on derivative contracts, specifically options. By buying and selling call and put options that share the same strike price and expiration date, market participants map out the identical profit and loss curve of the target asset.
Elephants often utilize these structures for capital efficiency or to navigate market restrictions. In many international markets, shorting a stock is expensive due to high borrowing fees. In other jurisdictions, local financial regulators prohibit the direct short selling of specific equities entirely. A synthetic short position bypasses the need to borrow the underlying shares, allowing the trader to take a bearish stance without executing a traditional short sale.
The pricing of synthetic positions is governed by the financial principle of put-call parity. This principle dictates that the price of a call option implies a specific fair value for the corresponding put option. If the synthetic version of an asset is priced differently than the actual asset, arbitrageurs buy the cheaper version and sell the more expensive one. This continuous market activity keeps options and stock prices aligned across global exchanges.
Example
Suppose an Elephant trading on the London Stock Exchange expects the share price of Savannah Transport, a logistics firm specializing in the international relocation of zoo and sanctuary elephants, to decline. Borrowing the actual shares to short is difficult because institutional investors are currently holding the available stock. Instead of a direct short sale, the Elephant creates a synthetic short position.
To do this, the trader buys a put option on Savannah Transport and simultaneously sells a call option on the same stock. Both options have a strike price of 50 pounds and an expiration date of December 15. If the stock price falls below 50 pounds, the put option gains value, mimicking the profit of a standard short sale. If the stock price rises above 50 pounds, the sold call option generates a financial loss, exactly matching the risk of holding a short stock position.