Synthetic Futures

Synthetic Futures refers to a financial instrument or trading strategy that simulates a futures contract's characteristics and potential returns. The purpose is to achieve specific investment objectives or to bypass certain limitations associated with trading actual futures contracts.

These contracts are usually standardized and traded on exchanges. However, synthetic futures offer an alternative approach by using other financial instruments to replicate futures contracts' exposure and potential profits or losses. It is important as they can offer flexibility, cost efficiency, and customization, allowing investors to tailor their positions based on their risk tolerance and market outlook.

• Synthetic futures are financial instruments or trading strategies that replicate traditional futures contracts' characteristics and potential returns using other financial instruments such as options, swaps, or CFDs.
• Synthetic futures offer flexibility, cost efficiency, and customization, allowing investors to tailor their positions based on their risk tolerance and market outlook.
• They can be used to achieve specific investment objectives, bypass limitations associated with traditional futures contracts, and provide alternative trading strategies and risk management tools.
• Synthetic futures can be created using options by combining call and put options to mimic the payoff of long or short futures contracts.

A synthetic futures contract is a financial instrument that replicates the payoff of a traditional futures contract using other financial instruments such as options, swaps, or contracts for difference (CFDs). Let us look at how each of these methods can be used to create synthetic futures:

1. Options: To create a synthetic futures contract using options, an investor would buy a call option and sell a put option on the same underlying asset with the same expiration date. This position is known as a synthetic long futures contract. Conversely, an investor could buy a put option and sell a call option on the same underlying asset to create a synthetic short futures contract. The payoff of the synthetic futures contract is similar to that of a traditional futures contract. Still, it does not require the investor to put up the margin or collateral required for a traditional futures contract.
2. Swaps: A swap is a financial agreement between two parties to exchange cash flows based on an underlying asset. In the case of a synthetic futures contract, an investor would enter into a swap agreement to exchange cash flows based on the underlying asset's price movements.
3. Contracts for Difference (CFDs): CFDs are derivative contracts that allow investors to speculate on the price movements of an underlying asset without actually owning it. To create a synthetic futures contract using CFDs, an investor would enter into a CFD agreement to receive cash flows based on the underlying asset's price movements.

There are several types of synthetic futures contracts that can be created using different financial instruments. Let us look at a few common types:

1. Synthetic Long Futures: This type replicates the payoff of a long futures contract. It involves creating a position that benefits from an increase in the underlying asset's price. Investors can use options, swaps, or CFDs to create this long future exposure.
2. Synthetic Short Futures: This type replicates the payoff of a short futures contract. It involves creating a position that profits from a decrease in the underlying asset's price. Investors can use options, swaps, or CFDs to create this short futures exposure.
3. Synthetic Calendar Spreads: This type involves creating a position that simulates the characteristics of a calendar spread strategy. A calendar spread involves simultaneously buying and selling futures contracts with different expiration dates on the same underlying asset. By using options or combinations of options and futures, investors can construct synthetic calendar spreads to take advantage of price differentials between different contract months.
4. Synthetic Straddle or Strangle: These types of futures contracts involve creating a position that mimics the behavior of a straddle or strangles strategy. A straddle involves buying both a call option and a put option with the same strike price and expiration date. At the same time, a strangle involves buying a call option and a put option with different strike prices but the same expiration date. Synthetic versions of these strategies can be constructed using options to simulate the original strategies' potential profit or loss patterns.

Let us look at the examples to understand the concept better.

Example #1

Consider an investor who purchases a call option on Company ABC stock for $10, with a strike price of $50 and an expiration date of one month. This call option gives the investor the right, but not the obligation, to buy Company ABC stock at $50 per share within the specified timeframe. Simultaneously, the investor sells a put option on Company ABC stock for $5, with the same expiration date and a strike price of $50. The investor must buy Company ABC stock at $50 per share by selling the put option if the counterparty exercises the option. 

The investor has effectively created a synthetic long futures contract on Company ABC stock by combining these two options. Thus, he can profit from the price increase if the stock price rises above $50 within the specified timeframe.

Example #2

Let's say an investor wants to replicate the payoff of a long futures contract on Bitcoin. Instead of trading the futures contract, the investor creates a synthetic long futures position using a Bitcoin perpetual swap contract on a cryptocurrency exchange.

The investor enters into a perpetual swap agreement that tracks the price of Bitcoin. The perpetual swap contract is a derivative instrument that mimics the price movements of Bitcoin without an expiration date. By trading the perpetual swap, the investor can gain exposure to the price movements of Bitcoin. It is similar to holding a long futures contract on the cryptocurrency.

This synthetic futures position offers flexibility and convenience. It allows the investor to speculate on the price of Bitcoin without physical ownership or on a futures exchange. However, it's important to consider the risks and factors specific to cryptocurrency trading. Like volatility, liquidity, and regulatory considerations, before engaging in such futures trading with Bitcoin or any other digital asset.

Let us have a look at the pros and cons of the concept.

This article has been a guide to Synthetic Futures and its definition. We explain the topic in detail including its examples, advantages, disadvantages, & types. You may also find some useful articles here -

• Synthetic Position
• Synthetic Options
• Equity Swaps