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?
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?