Understanding The Short Synthetic Future Strategy

By leveraging this strategy, an investor can take advantage of his or her bearish outlook while mitigating some of the challenges of directly trading futures 

In the previous issue, we explored the Long Synthetic Future strategy, which allowed our assumed investor Sarvani Shah to mimic the payoff of a futures contract without holding the actual futures. This time, Sarvani encounters another facet of synthetic futures as she learns about its counterpart—the Short Synthetic Future. This strategy, designed for traders with a bearish market outlook, offers flexibility and efficiency while mimicking the payoff structure of a short futures position.

What is a Short Synthetic Future?
A Short Synthetic Future is created by selling an at-the-money (ATM) call option and buying an ATM put option on the same underlying asset, with the same strike price and expiration date. The strategy mirrors the payoff of a short futures contract, where the trader profits when the underlying asset’s price declines and incurs losses when the price rises.

Why Short Synthetic Future?
The Short Synthetic Future is particularly appealing for traders who:
1. Anticipate a decline and expect the underlying asset’s price to fall over a defined period.
2. Avoid futures margins and want to mimic a short futures position without being subjected to margin requirements or the risk of margin calls.
3. Need cost efficiency since the strategy can require less upfront capital than directly shorting futures.

By leveraging this strategy, Sarvani can take advantage of her bearish outlook while mitigating some of the challenges of directly trading futures.

Executing the Short Synthetic Future
Here’s how Sarvani sets up her Short Synthetic Future:
• Nifty Current Market Price: ₹24,100
• ATM Strike 24,100 CE Price: ₹480
• ATM Strike 24,100 PE Price: ₹290
• Expiry Date: December 26, 2024.

Sarvani sells the ATM call option at ₹480 and buys the ATM put option at ₹290, resulting in a net credit of ₹190 (₹480 – ₹290).

Breakeven Point
The breakeven point for a Short Synthetic Future is calculated by subtracting the net credit received from the strike price:
• Breakeven Point = Strike Price – Net Credit = 24,100 – 190 = ₹23,910.
• If Nifty remains below ₹23,910 by expiry, Sarvani’s position will start showing a profit.

Payoff Structure
The payoff for the Short Synthetic Future mirrors the behaviour of a short futures position. Here’s the breakdown:

1. If Nifty falls below ₹23,910 (breakeven point):
• The put option gains intrinsic value as Nifty’s price declines.
• The call option expires worthless.
• Net profit = (24,100 – Nifty price) + 190.

2. If Nifty remains at ₹24,100 (strike price):
• The call and put options lose value, but the net credit is retained as profit.
• Net profit = ₹190. 3. If Nifty rises above ₹24,100:
• The call option incurs a loss, while the put option expires worthless.
• Total loss = (Nifty price – 24,100) – 190.

Payoff Diagram

Payoff Table

The table highlights that Sarvani’s maximum profit occurs when Nifty falls significantly below Rs 23,910, and her losses increase if Nifty rises above Rs 24,100.

Short Synthetic Future vs Long Synthetic
Future Both Short Synthetic Future and Long Synthetic Future replicate the payoff of short and long futures contracts, respectively, but they differ in their market outlook and payoff behaviour:

1. Market Outlook
• Long Synthetic Future: Used when the trader expects a bullish market.
• Short Synthetic Future: Ideal for bearish market conditions.

2. Setup
• Long Synthetic Future: Involves buying an ATM call and selling an ATM put.
• Short Synthetic Future: Involves selling an ATM call and buying an ATM put.

3. Profit Behaviour
• Long Synthetic Future: Profits as the market rises.
• Short Synthetic Future: Profits as the market declines.

4. Breakeven Point
• Long Synthetic Future: Strike Price + Net Debit.
• Short Synthetic Future: Strike Price – Net Credit.

5. Risk Management
• Both strategies limit risk to the premiums paid or received, offering a controlled alternative to traditional futures.

Conclusion
The Short Synthetic Future provides traders like Sarvani a valuable tool for bearish markets, allowing her to profit from the declining prices without the complexities of directly trading futures. With its cost efficiency and flexibility, the strategy aligns well with her market view, ensuring that her trading repertoire remains dynamic and well-rounded. As Sarvani reflects on her journey from option spreads to synthetic futures, she appreciates the adaptability these strategies offer. The comparison with the Long Synthetic Future reinforces her understanding of how to tailor strategies to market conditions. By mastering these approaches, Sarvani continues to grow as a trader, ready to navigate both bullish and bearish markets with confidence.