Understanding The Synthetic Future Strategy

In this issue, we follow Sarvani Shah as she continues to expand her trading knowledge. After successfully using various option spreads, Sarvani finds herself exploring a new strategy that provides a unique way to gain exposure to the market— without buying a futures contract directly. This brings her to the concept of Synthetic Futures, a strategy designed for traders who want to mimic the payoff of a futures contract using options 

Over the past few issues, Sarvani Shah has applied various option spreads to navigate bullish, bearish, and even sideways markets. However, she has recently been drawn to a strategy that doesn’t require her to hold a futures contract yet provides similar exposure to the underlying asset. Sarvani’s interest piqued when she noticed the potential of Synthetic Futures, a technique that involves combining call and put options to replicate the payoff structure of a futures contract. With Nifty currently trading around 24,100, Sarvani decides to experiment with Synthetic Futures as she looks for efficient ways to gain direct market exposure.

What is a Synthetic Future?
A Synthetic Future is created by simultaneously buying an at-the-money (ATM) call option and selling an ATM put option on the same underlying asset, with the same strike price and expiration date. This combination mimics the payoff of a long futures contract, as any change in the underlying asset’s price directly affects the combined option position. Synthetic Futures allow traders like Sarvani to experience a near 1:1 exposure to the asset’s price movement without holding an actual futures contract.

Why Synthetic Futures?
The Synthetic Future strategy offers several benefits:

1. Reduced Capital Requirement - Unlike futures contracts, which require margin, Synthetic Futures allow traders to gain similar market exposure with lower initial capital outlay. The premiums of the call and put can partially offset each other, reducing the net cost of entry.
2. Flexible Positioning - By using options to simulate futures, traders can adjust their exposure more easily without the commitment required in traditional futures.
3. No Expiry Rollover - With Synthetic Futures, Sarvani can mimic futures positions without the hassle of rolling over her position each month, as she would with actual futures contracts.

Executing the Synthetic Future
Let’s look at Sarvani’s Synthetic Future setup:
• Nifty Current Market Price: ₹24,100
• ATM Strike 24,100 CE Price: ₹300
• ATM Strike 24,100 PE Price: ₹265
• Expiry Date: November 28, 2024.

Sarvani initiates the Synthetic Future by buying the ATM call (24,100 strike) at ₹300 and selling the ATM put (24,100 strike) at ₹265. This combination results in a net debit of ₹35 (₹300 - ₹265).

Breakeven Point
The breakeven for Sarvani’s Synthetic Future position is calculated by adding the net debit paid to the strike price: Breakeven Point = Strike Price + Net Debit = 24,100 + 35 = ₹24,135

If Nifty moves above ₹24,135 by the expiration date, Sarvani’s position will start showing a profit.

Payoff Diagram

Payoff Table

The table shows that Sarvani’s Synthetic Future closely follows the Nifty’s price movements, providing similar exposure as if she held a direct futures position.

Payoff Structure
The Synthetic Future strategy payoff closely mirrors the price movements of the underlying asset, similar to a futures contract but with a slight adjustment for the net debit. Here’s how Sarvani’s potential payoff could look based on Nifty’s closing price at expiry:

1. If Nifty rises above ₹24,135 (Breakeven Point):
• The call option gains intrinsic value as Nifty’s price increases.
• The put option expires worthless.
• Net Profit = (Nifty price - 24,135).

2. If Nifty stays at ₹24,100 (Strike Price):
• Both options have negligible intrinsic value, resulting in a loss equal to the initial debit.
• Net Loss = ₹35.

3. If Nifty falls below ₹24,100:
• The call option expires worthless, and the put option incurs a loss.
• Total Loss = Initial debit of ₹35 + (Strike price - Nifty price below breakeven).

Synthetic Future versus Regular Future Contract
While the Synthetic Future provides direct exposure to Nifty’s price movement, it differs in several ways from holding a regular futures contract: egular futures contract:

1. Capital Efficiency - Synthetic Futures generally require lower initial capital than a regular futures contract since they involve option premiums rather than margin.
2. Flexibility with Strike Prices - By adjusting the strikes of the call and put options, Synthetic Futures can be customised to provide varying degrees of exposure, while a regular future has a fixed 1:1 exposure.
3. Risk of Early Assignment - Since Synthetic Futures are based on options, there is a possibility of early assignment if the put option moves in-the-money. Futures contracts, however, do not carry this risk.
4. No Margin Calls - Regular futures contracts are subject to margin calls if the position moves against the trader,whereas Synthetic Futures only carry the risk of the net debit paid upfront.

In Sarvani’s case, she appreciates the cost efficiency and flexibility that Synthetic Futures provide, especially since her bearish outlook means she can carefully control her exposure.

Conclusion
For Sarvani, Synthetic Futures provide a new way to experience market exposure without the complexities of traditional futures contracts. By combining ATM call and put options, she can gain a near 1:1 exposure to Nifty’s price movement. As she explores this strategy further, Sarvani understands that Synthetic Futures can be valuable for direct exposure while managing capital more efficiently. With Synthetic Futures added to her trading repertoire, Sarvani’s journey through options trading continues with new strategies and growing confidence.