What are the benefits of synthetic trading for institutional investors?

What is synthetic trading?

A synthetic is a financial instrument that has been engineered to mimic the performance of other instruments, such as stocks and currencies, whilst changing the instrument’s key characteristics. These are usually custom-made investments designed specifically for large investors and are tailored to offer cash flow patterns, maturities and risk profiles, depending on a hedge fund’s needs.

However, one of the most frequent ways of using synthetic trades is for options trading, as it’s often much easier to create a synthetic asset rather than borrow a stock or provide the capital required to take a short or long position on a regular stock.

The result of a synthetic trade can be very similar to that of the position it’s imitating as the profit or loss is often the same. But if the risk and reward ratio of a synthetic trade is potentially the same as investing in the actual asset itself, what are the advantages of synthetic trading?

The benefits of synthetic trading

Above all else, synthetic trading allows investors to benefit from greater flexibility and reduced risk. With synthetic trades, it can often be relatively easier to switch your position on a stock without risking heavy losses, which can be particularly useful if market performance is different to your expectations or is rattled by unforeseen events.

For example, imagine an investor has a short position on a stock that they originally expected to drop in price over a two-week period but due to unforeseen circumstances the market performance changes and now they believe the stock price will increase. If the investor wants to benefit from the stock’s increase as they did from its fall, they would need to close their short position and write puts - possibly at a loss.

With synthetic trading, however, the investor could recreate the short put options position by buying the underlying stock. This is essentially a synthetic short put, as the investor is short on calls but long on the actual stock. Now the investor has an advantage with their synthetic position as they will only have to place one order to buy the underlying stock rather than two orders; one to close their short call position and another to open their short put position.

Whilst that is perhaps the greatest advantage of synthetic trading, one of the other key benefits of synthetic options is the reduced need for upfront capital. Essentially, investors and traders can take synthetic long or short positions without laying out the capital required to actually buy or sell an asset. This tends to be much easier than borrowing the stock and selling it short, or outlaying the capital required to actually buy the stock in order to take a long position.

The risks of trading synthetic options

Although trading synthetic options can be advantageous compared to regular options trading, there are some risks and challenges that investors should bear in mind.

For example, if market performance starts to move against a cash or futures position then the investor would be losing money in real-time. Of course, the idea is that if an investor has a protective option in place then its value will increase at the same speed as that of the declining asset in order to cover the losses. This is, however, achieved best with an “in the money” option, but these are more expensive than “out of the money” options. As such, this can have an unfavourable effect on the capital committed to a trade.

Although an “in the money” option is more suited to protect against potential losses, it’s important that investors have a money management strategy to determine when they should exit the cash or futures position. Without a management strategy, traders risk missing the opportunity to switch out a synthetic position that’s losing, for one that will turn a profit.

Furthermore, if market performance stays fairly flat with little fluctuation in price, then an “in the money” position may lose its value over time.

The advantages of synthetic options

In many ways, synthetic options can open up new opportunities, as well as save investors time and help them to remain objective when opening new positions. When they’re done right and used efficiently, synthetics can often simplify the decisions that come with investing.

Rather than spending lots of time going through information around an asset and working out if it will make a profitable enough return, the safety net that comes with trading synthetic options should help ease the decision-making process. Moreover, synthetic options can help reduce the costs of investing and help traders manage their positions more effectively.

Synthetics are also particularly useful tools for short sellers as well as traders don’t need to borrow an asset in order to take a short position, which simplifies the process and cuts down on cost.