What Are Synthetic Options and How Do They Work?

Synthetic options provide traders with an alternative way to manage risk and capitalize on specific market opportunities. Unlike standard option strategies, synthetic strategies involve combining underlying assets with options to replicate similar payoffs. While they don’t always require less capital, they offer strategic advantages—such as dividend capture—when applied in the right conditions. This article explores the definition, uses, and key differences between synthetic and standard options strategies.

Key takeaways

• Synthetic options are a financial tool that allows traders to replicate the payoff of traditional calls or puts using a combination of underlying assets and options.
• They offer strategic flexibility, allowing traders to take advantage of specific market conditions, such as dividend capture.

What Are Synthetic Options

Synthetic options are a trading tool that mimics the results of traditional options by combining underlying assets with specific option strategies. This approach offers traders an alternative to regular options, reducing the risk of holding contracts that expire worthless. Unlike traditional “vanilla” options, synthetic options can be structured to mitigate certain risks, such as the impact of time decay and volatility, depending on how the position is constructed.

In terms of terminology, we should clarify that “synthetic shares” are options strategy replicating holding a long or short position on stocks (like the long call and the long put). Instead, a synthetic option is a strategy replicating a different option strategy, typically for a much lower cost.

Here are the two most basic types of synthetic options:

• Synthetic Call Strategy: A long position of the asset or futures paired with a put option. This setup mirrors the profit potential and limited loss of a standard call option.
• Synthetic Option Strategy for Puts: A short position of the asset or futures combined with a call option, replicating the payoff of a regular put option.

The concept of put-call parity is at the core of synthetic options. It states that the relationship between puts, calls, and their underlying asset creates opportunities to replicate options positions. This principle ensures that synthetic options align closely with their traditional counterparts in performance. Additionally, traders can use synthetic options to determine the interest rate or dividend yield implied in option prices, as these factors play a key role in put-call parity.

For traders seeking control and reduced downside, synthetic options provide a practical solution. Since we mentioned the idea of put-call parity, let’s spend a few words on the topic in the next section.

Put-Call Parity – The Basis of Synthetic Options

At the core of synthetic options lies the concept of put-call parity. This principle establishes a critical relationship between European call and put options with the same underlying asset, strike price, and expiration date. Put-call parity ensures that any deviation in the prices of these options creates opportunities for synthetic strategies.

The relationship is expressed mathematically as:

where:

• C = Price of the European call option
• P = Price of the European put option
• PV(x) = Present value of the strike price, discounted at the risk-free rate
• S = Spot price of the underlying asset

Put-call parity allows traders to construct synthetic options strategies, such as a synthetic call strategy, by combining options and the underlying asset to replicate the payoff of traditional options. For example, a synthetic call mimics a long call option’s payoff by pairing a long stock position with a put. Similarly, a short stock position combined with a call creates a synthetic put.

If the put-call parity relationship breaks, an arbitrage opportunity emerges. Traders can exploit the mispricing to generate risk-free profits—though such opportunities are rare in efficient markets. For most traders, understanding put-call parity is less about arbitrage and more about using synthetic options to manage risk and deploy capital effectively. By leveraging this principle, synthetic options provide flexibility and cost-efficiency, empowering traders to replicate positions without directly purchasing traditional options.

A Look at Popular Synthetic Options Strategies

If this is the first time you hear about synthetic options, you may want to start with the basics. These strategies provide cost-effective solutions for managing risk and maximizing returns. Below, we’ll explore two of the most popular synthetic options strategies – synthetic calls and synthetic puts – and their practical applications.

Synthetic Calls

A synthetic call combines a long position in the underlying stock or asset with a long at-the-money put option. Your typical synthetic call P&L graph will look like this:

As you can see from the chart above, the synthetic call replicates the payoff of a traditional call option (capped losses vs. potentially unlimited profits). Let us tell you more about it below.

How It Works

The key idea behind the synthetic call strategy is to pair a long position in the asset with a protective put option. For instance, if you’re holding shares of a stock, buying a put option at the current price ensures that any drop in value below the strike price won’t result in unlimited losses. The payoff structure mirrors that of a regular call option – unlimited profit potential if the stock rises and limited loss potential on the downside (equal to the cost of the put).

Imagine you hold a long position in the VIX (volatility index) during a turbulent market period. To protect your investment from sudden price drops, you could implement a synthetic call strategy by purchasing an at-the-money put option. If the market stabilizes and the VIX declines, your losses are limited to the cost of the put option. On the flip side, if market volatility spikes and the VIX rises sharply, you stand to benefit from the upside potential.

Synthetic Puts

A synthetic put consists of a short position on the underlying asset combined with a long at-the-money call option. This setup allows traders to replicate the risk-reward profile of a regular put option.

How It Works

To create a synthetic put, traders short the underlying stock or asset and hedge that position by buying a call option at the current price. Your typical synthetic put P&L graph will look like this:

As you can see from the chart above, this synthetic option strategy protects the trader from upward price movements while benefiting from a decline in the asset’s value, just like a standard put option.

Suppose you’re shorting META (formerly Facebook) because you believe its stock price will decline after an upcoming announcement. To hedge this short position, you purchase an at-the-money call option on the stock. If META’s price drops, you profit from the short position. However, if the announcement surprises the market and META’s stock surges, the call option limits your losses, ensuring you won’t face unlimited risk.

The Appeal of Synthetic Options – An Example

There are actually more advanced ways to use synthetic options, and we wanted to spend a few words on this matter. In fact, we believe an example will give you a better idea of how this works. Consider a classic covered call strategy first, then compare it to its synthetic alternative.

Imagine DELL stock is trading at $127.70. With a standard covered call, you may look at our screener for the options market and buy 100 shares at $12,770 while selling a $121 call option. This is your P&L:

Selling the option might earn you an $855 premium (assuming a midpoint price of $8.55). Your net investment would then be $11,915 ($12,770 minus $855). While this is a valid approach, committing over $12,000 may feel excessive for some traders.

Now, using a poor man’s covered call, you reduce your capital outlay significantly. Instead of buying 100 DELL shares outright, you purchase a deep in-the-money call for a fraction of the cost. For instance, a $60 call expiring in six months may cost $6,670. Pair this with selling a $121 call, just like in the previous example. As you may guess, your P&L will look quite similar to the previous one.

While this is not a synthetic call in the strictest sense, it is a synthetic way to replicate a covered call strategy with less capital. A true synthetic call would involve buying a put instead of purchasing a deep ITM call, turning the position into a spread—just like when buying a call and selling another call.

This synthetic covered call (also known as “poor man’s covered call”) lowers your initial cash requirement by over 50% while keeping a similar profit and loss profile.

Key Advantages of the Synthetic Covered Call Strategy

• Lower Capital Exposure: You eliminate the need to purchase the stock directly by using synthetic shares, making this strategy more budget-friendly.
• Income Potential: After your first call expires, you can sell additional short-term calls to generate further income.

The flexibility of the synthetic call strategy provides an efficient way to trade while managing capital and risk effectively. Keep in mind, though, that since you don’t own the actual stock, you won’t qualify for dividends. If you are interested in this class of trades, you can check out our article on the synthetic long strategies.