“The past is certain, the future obscure”
Thales of Milletus
First of all, we must define what a derivative is. It is simply a security whose price relies upon another asset – called an underlying asset. An S&P future and an American call option are derivatives.
A security is a non-negotiable financial instrument with monetary value – you may sell it for cash. It could be the minimum part of a company (a stock) or one bushel (60 pounds) of soybeans.
A synthetic position, for all matters, could be created by buying or shorting the underlying financial instruments or derivatives. For instance, you could purchase a call option and sell a put option of the same security, creating for yourself a synthetic stock.
What would I need a synthetic derivative for?
If you’re a soybean farmer and you feel you need to protect the cash value of your production because its market value might fall, you may go straight to the financial market to solve that!
What would you seek? Well, there are two very popular choices:
- Sell the number of soybean future contracts equivalent to your crop’s size or
- Open a put option for about twice the value of the contracts you would short in the first option
While shorting numerous contracts, you’re dealing with unlimited risks. Prices might climb and you’ll end up with debt – whenever you’re closing your position, you must pay the difference between prices or profit if the underlying price went into the direction “you wanted”.
On the other hand, your put option will limit your risk but you might have paid an expensive price to have the right, but not the obligation to sell your soybean bushels at a predetermined price.
If you want to risk less capital, use a synthetic position.
When trading futures, operational costs are lower. A synthetic position for hedging your crop of soybean would be a synthetic short call:
- Write put options of the asset
- Short sell the underlying asset
Your new position is just like a short call option with lower costs and risks.
A deeper look into synthetic securities
A synthetic security is a linear combo of multiple primary instruments in the markets. Therefore, you should be able to emulate positions depending on your needs – hedging your production, investments, equities…
Far from rocket science: you simply open your home broker and send your orders – only if you’re aware of what you’re doing.
Synthetics are mostly used for hedging general positions or hedging nonlinear derivatives. The payoff of a nonlinear derivative won’t be defined by a linear function.