The synthetic short futures is an options strategy used to simulate the payoff of a short futures position. It is entered by selling at-the-money call options and buying an equal number of at-the-money put options of the same underlying futures and expiration date.
Buy 1 ATM Put, Sell 1 ATM Call
This is an unlimited profit, unlimited risk futures options position that can be constructed to hedge a long futures position, often as a means to profit from an arbitrage opportunity. The synthetic short futures strategy is also used when the futures trader is bearish on the underlying futures but seeks an alternative to selling the futures outright.
Unlimited Profit Potential
Similar to a short futures position, there is no maximum profit for the synthetic short futures. The options trader stands to profit as long as the underlying futures price goes down.
Unlimited
Profit achieved when: Price of Underlying < Strike Price of Long Put + Net Premium Received
Profit = Strike Price of Long Put - Price of Underlying + Net Premium Received
Unlimited Risk
Like the short futures position, heavy losses can occur for the synthetic short futures if the underlying futures price shoots upwards.
Unlimited
Loss occurs when: Price of Underlying > Strike Price of Short Call + Net Premium Received
Loss = Price of Underlying - Strike Price of Short Call - Net Premium Received + Commissions Paid
Breakeven point
Strike Price of Long Put + Net Premium Received
Example
Suppose June Crude Oil futures is at $40 and each contract covers 1000 barrels of Crude Oil. An options trader enters a synthetic short futures position by buying a JUN Crude Oil 40 put for $5100 and selling a JUL 40 call for $4800. The net credit taken to enter the trade is $300.
Scenario #1: June Crude Oil futures rises to $50
If June Crude Oil futures rallies and is trading at $50 on option expiration date, the long JUN 40 put will expire worthless but the short JUN 40 call expires in the money and has an intrinsic value of $10000. Buying back this short call will require $10000 and subtracting the initial $300 credit taken when entering the trade, the trader's net loss comes to $9700. Comparatively, this is very close to the net loss of $10000 for the short futures position.
Scenario #2: June Crude Oil futures drops to $30
If June Crude Oil futures is instead trading at $30 on option expiration day, then the short JUN 40 call will expire worthless while the long JUN 40 put will expire in the money and be worth $10000. Including the initial $300 credit received on entering the trade, the trader's profit comes to $10300. This amount closely approximates the $10000 gain of the corresponding short futures position.
Upfront Investment
Some novice futures traders mistakenly believe that the synthetic short futures strategy requires very little upfront investment. They assumed that by trading options instead of futures, they can avoid posting the margin. Unfortunately, the short call position is subjected to the same margin requirements as a long futures position. Hence, the synthetic short futures position requires more or less the same upfront investment as a regular short futures position.
Synthetic Short Futures (Split Strikes)
There is a less aggressive version of this strategy where both the call and put options involved are out-of-the-money. While a larger downside movement of the underlying futures price is required to make large profits, this split strikes strategy does provide more room for error.
Synthetic Long Futures
The converse strategy to the synthetic short futures is the synthetic long futures, which is used when the options trader is bullish on the underlying but seeks an alternative to purchasing the futures itself.