Futures Get into Low Cost Futures Trading with Synthetics

There is a constant push for portfolio diversification into alternative investments, such as futures and commodities, but oftentimes it is difficult to make the leap. That's where the concept of synthetic futures comes in. For those looking to avoid a huge initial investment and manageable risk, synthetic futures provide an opportunity to help you ease into portfolio diversification without betting the farm.

An Influential Study
In 2004, a brief but powerful white paper was put out by the Yale International Center for Finance. The paper was entitled "The Facts and Fantasies about Commodity Futures". In the paper, the authors set out to answer two questions

Are commodity futures riskier than stocks?

Can commodity futures provide diversification to other asset classes?

The answer to the first question was a resounding "no". The study revealed that more than 45 commodity futures were not only comparable to the S&P 500, but they also consistently outperformed corporate bonds. In fact, both the S&P 500 and commodity futures shared an average return of 11.02%. When the standard deviation was taken into account, the S&P 500 returns came out slightly higher, at 14.9%, and commodity futures moved up to 12.12%.

The answer to the second question was a resounding "yes". In order to best determine whether commodity futures and the S&P 500 were correlative or not, the white paper examined three different time intervals: every quarter, every year and every five years. Their research revealed that the best benefit of commodity futures was the fact that they negatively correlate with different asset classes, and as time goes on, the negative correlation steadily increases. This was a significant discovery.

In the months in which equity markets performed worst, commodity futures actually gained in value. The Yale study found that during some of their worst months (the lowest 1% of months in terms of performance of equity markets), stocks fell an average of 13.87% while commodities returned an average 2.32%. When the stocks fell an average of 9.18% (during the lowest 5% of months in terms of performance of equity markets), commodities were returning 1.43%.

Time to Consider Synthetic Futures
Even though there is a clear argument for investors to diversify into alternative investments, the fear - whether irrational or rational - of venturing out into futures is difficult for the majority of investors to overcome. In fact, the futures industry itself doesn't encourage investors to make the leap. The risk disclosure states that you may lose your entire investment and more when you invest in futures. This is far from encouraging.

The alternative is to invest in options on futures, but they have their own problems. While options have the ability to limit your risk to the amount you invest, they are difficult to pick. You have to decide if you are going to purchase an option "out of the money", "at the money" or "in the money". While deciding that, you also have to determine which one closely follows the underlying futures. In addition, the closer you want your option to be to the current futures price at the money or in the money, the more you will have to pay. The additional costs can be attributed solely to the amount of volatility affecting the contract at the time

When futures seem scary because you can lose more than you expected, and the options that are the most likely to succeed are prohibitively expensive, investors can turn to the alternative: synthetic futures. They combine the best of both worlds - they allow you to follow the underlying futures as closely as possible to turn a profit, they help reduce the amount you have to spend on an in-the-money option, and they have the ability to minimize your risk when used properly.

Types of Synthetic Futures
There are two types of synthetic futures, a synthetic long and a synthetic short.

A synthetic long entails two transactions: purchasing an at-the-money call option, and selling an at-the-money put. For example, if the gold market was at $960 and you felt that it was going to $1,000, to trade the futures outright you would have to put $4,725 in margin (common margin requirement). The options on this same contract are a lot less. For example, an at-the-money $960 call is priced at $2,710, and an at-the-money put is priced at $2,500.

By purchasing the call outright, you immediately benefit from a $2,015 savings over having to put in $4,725 for the futures margin. A synthetic long is created by taking the process one step further - selling the at-the-money put for $2,500. This brings your total cost for the call down from $2,710 to $210 (the amount paid, minus the collected premium: $2,710 - $2,500 = $210 spent). So, while putting on the outright futures would have cost you $4,725 up front, the same position as a synthetic long would cost you only $210. That's a savings of $4,515.

A synthetic short is just the opposite - you purchase an at-the-money put and sell an at-the-money call. Let's take the same gold example. The market is at $960 and you decide to purchase an at-the-money $960 put for $2,500. By purchasing the put outright you have a savings of $2,225 over the futures. By taking the process one step further and selling an at-the-money call for $2,710, you turn your position into a synthetic short. This actually makes the put you bought cost nothing, and adds an additional $210 to your account (the amount paid, minus the collected premium: $2,500 - $2,710 = $210 profit).

Pros and Cons
So, if you decide to take advantage of a synthetic long position it would cost you only $210, and if you decide to take advantage of a synthetic put position it would cost nothing. This is a big difference from the required $4,725 you would have to have as margin if you decided to trade a futures contract by itself.

With synthetic futures as with everything else, there is still plenty of opportunity for loss. While it may cost less to place the position, you are still exposed to the same unlimited loss that's typical of an outright futures position. The question you have to ask yourself is whether it's more feasible to risk a few hundred dollars on the position or put up several thousand. Depending on your answer, the tools you would use to protect yourself from losing it all in a futures position are the same tools you would use in a synthetic futures position: stop-loss orders, limit orders and protective options. There are subtle and few differences in their execution.

In Summary
While there is constant pressure to diversify your portfolio with commodity futures from magazines, white papers and newspapers, it only makes sense to do so if you can afford the risk capital and feel comfortable with the amount you are risking. For those unable or unwilling to trade commodity futures outright, synthetic futures can provide just that type of opportunity.

Noble Drakoln can be contacted at SmallSpeculators.com
 
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jason

you seem to have forgotten one major point which makes this article useless

so in your first example if you sell a put (firstly there will be a spread so the price to buy a put is not the same amount as selling the put but even without that)
whenever you sell an option you have to have margin to cover you just incase it goes against you. so in this case every broker would require a margin just in case it went below $960
i fail to see any logic in this. especially as you would be paying two spreads and option spreads are much wider than future or spot spreads.

easiest way is to open a high margin cfd account and if you are lucky place a guaranteed stop to lower the margin requirement
 
What about MArgin

"<span>the same position as a synthetic long would cost you only $210. That's a savings of $4,515."
</span>1) In both examples what about the the margin that is required for the naked soled option leg?
SO for a synthetic long the ATM PUT is a naked position and wil require similar margin to a Futures position
The article sound s like IT will only cost 210 instead of 4995, How accurate is that? something does not match!
Yes it is true that the $2500 you receieved will reduce the cost of purchasing the CALL
2) Are you not mixing "Margin" which is refundable as compared to "premium" that is not refundable!
 
http://www.theoptionsguide.com/synthetic-long-futures.aspx
This I think clarifies the point ( same one Jason made about this article)
What would be more intersting is if an expert can write about Arbitrage between
Sunthtic Long using options and/ Underlying short
- Is it doable?
- does it exist?
- What margins are required?

Upfront Investment
Some novice futures traders mistakenly believe that the synthetic long 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 put position is subjected to the same margin requirements as a short futures position. Hence, the synthetic long futures position requires more or less the same upfront investment as a regular long futures position.
 
This has got to be the worst advice ever... as mentioned in the other comments, margin is necessary on the short put...

And on top of that, the spreads in options are always bigger than in the futures... doubling that spread, since trading in a call and in a put... makes a synthetic a lot more expensive than the future... except if you're a pro, you might be able to get a decent price on the synthetic vs future (so called reversal or conversion).

And I almost forgot, broker fees are typically higher on options than on futures, again x2...

This article is rubbish...
 
this has got to be the worst advice ever... As mentioned in the other comments, margin is necessary on the short put...

And on top of that, the spreads in options are always bigger than in the futures... Doubling that spread, since trading in a call and in a put... Makes a synthetic a lot more expensive than the future... Except if you're a pro, you might be able to get a decent price on the synthetic vs future (so called reversal or conversion).

And i almost forgot, broker fees are typically higher on options than on futures, again x2...

This article is rubbish...

agreed
 
http://www.theoptionsguide.com/synthetic-long-futures.aspx
This I think clarifies the point ( same one Jason made about this article)
What would be more intersting is if an expert can write about Arbitrage between
Sunthtic Long using options and/ Underlying short
- Is it doable?
- does it exist?
- What margins are required?

- Is it doable?
> yes, certainly...
- Does it exist?
> Synth long options and short underlying is called a 'reversal'. This is traded by pros all the time.
- What margins are required?
> Depends on how your broker calculates your margin. Since you're trading delta neutral, there shouldn't be too much margin...

However, there are some risks involved. You will have a dividend exposure (short dividend position in this case), you will have interest rate exposure and you will have an extra risk because you are short the underlying, and you pay interest to borrow the underlying to short it (in single stocks).

All costs involved makes this a no-no for retail traders. Usually pros trade this to reduce any dividend risk or long/short stock position. Or close out a position on their options books.

A large net long or short position in in stocks and synthetic futures is always risky in case of an upcoming corporate action.
 
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