What Is Synthetic Trading In F&O?

Futures and Options (F&O) trading is a popular segment of the derivatives market that offers traders tools to hedge, speculate, or enhance their portfolio efficiency. As you look further into F&O strategies, you may come across the term synthetic trading,  a concept that is less commonly utilised, yet powerful when applied correctly.

In the financial world, “synthetic” refers to a strategy or instrument engineered to replicate the payoff or behaviour of another financial position. Instead of taking a direct position in a stock or future, synthetic trading allows the trader to mimic that exposure using a combination of options or other derivatives.

This approach does not involve the physical purchase or sale of the underlying asset. Rather, it relies on options (calls and puts) structured in specific ways to replicate a desired outcome. For example, buying a call and selling a put at the same strike price can replicate owning the underlying stock. This is how synthetic positions work in practice.

In the Indian markets, where liquidity, taxes, and margin considerations are critical, synthetic trading in F&O can be a strategic tool for active traders. If you understand the components and risks involved, it can offer a cost-effective way to gain or hedge exposure.

Why Are Synthetic Positions Created?

Synthetic trading strategies are created for several reasons. Some of the most common include:

1. Capital Efficiency

Synthetic positions can replicate the payoff of a stock or future without tying up large amounts of capital. This allows you to maintain liquidity for other trades or investment opportunities.

2. Hedging

You may wish to hedge a current position without adjusting your actual holdings. A synthetic structure can protect against downside or upside movement while keeping the underlying intact.

3. Market Access

Sometimes, borrowing restrictions or regulatory constraints may prevent you from shorting a stock directly. In such cases, synthetic short positions offer a workaround using options.

4. Tax and Cost Considerations

Synthetic trades may lead to different tax treatments or transaction costs when compared to traditional positions. In certain scenarios, they can be more tax-efficient, especially under Indian taxation rules for derivatives.

5. Customisation

You can customise synthetic structures to suit your view on volatility, direction, and time - flexibility that standard stock or futures positions may not always offer.

Core Types Of Synthetic Positions In F&O

Let us explore the most commonly used synthetic positions in F&O. Each one involves a unique combination of options (and sometimes stock), designed to simulate the profit/loss structure of another asset or derivative.

A. Synthetic Long Stock (Synthetic Call)

• Structure: Buy a Call + Sell a Put (Same strike, same expiry)
• Purpose: Mimics a long stock position
• Used When: You are bullish on the stock and want exposure without buying the stock directly

This strategy behaves like owning the stock. If the stock price rises above the strike price, you gain. If it falls, you may face losses, similar to holding the stock.

B. Synthetic Short Stock (Synthetic Put)

• Structure: Sell a Call + Buy a Put (Same strike, same expiry)
• Purpose: Mimics a short stock position
• Used When: You expect the price to decline but cannot short-sell the stock directly

This allows you to profit from falling prices without borrowing the stock.

C. Synthetic Call (Long Stock + Long Put)

• Structure: Buy Stock + Buy Put
• Purpose: Mimics a long call option
• Used When: You want protection on your long position and expect limited downside risk

The put limits your downside, while the stock gives you upside exposure, resembling a call.

D. Synthetic Put (Short Stock + Long Call)

• Structure: Sell Stock + Buy Call
• Purpose: Mimics a long put
• Used When: You are bearish but want to limit the upside risk if prices move against your short

The call acts as insurance in case the stock moves higher.

Examples & Payoff Diagrams

To better understand synthetic trading, it’s important to look at how each structure behaves in real-market conditions. This section provides six detailed examples, showing the components, outcomes, and payoff diagrams for each synthetic position. 

Assumptions for all examples:

• Strike Price = ₹ 1,000
• Lot Size = 1
• Call Premium = ₹ 40
• Put Premium = ₹ 30
• Stock Price at Expiry: Ranges from ₹ 950 to ₹ 1,050
• Same expiry for all options

1. Synthetic Long Stock (Long Call + Short Put)

• Structure:
  • Buy 1 Call Option @ ₹ 1,000 = ₹ 40 (Premium Paid)
  • Sell 1 Put Option @ ₹ 1,000 = ₹ 30 (Premium Received)
• Net Cost = ₹ 10 (outflow)

Purpose: To mimic buying the underlying stock without actually owning it.

2. Synthetic Short Stock (Short Call + Long Put)

• Structure:
  • Sell 1 Call Option @ ₹ 1,000 = ₹ 40 (Premium Received)
  • Buy 1 Put Option @ ₹ 1,000 = ₹ 30 (Premium Paid)
• Net Credit = ₹ 10 (inflow)

Purpose: To simulate a short sale without borrowing stock.

3. Synthetic Long Call (Long Stock + Long Put)

• Structure:
  • Buy 1 Stock @ ₹ 1,000
  • Buy 1 Put Option @ ₹ 1,000 = ₹ 30 (Premium Paid)

Purpose: Provides limited downside (due to put) while retaining full upside, behaves like a long call.

4. Synthetic Short Call (Short Stock + Short Put)

• Structure:
  • Sell 1 Stock @ ₹1,000
  • Sell 1 Put Option @ ₹1,000 = ₹30 (Premium Received)

Purpose: Mimics the payoff of selling a call option.

5. Synthetic Long Put (Short Stock + Long Call)

• Structure:
  • Sell 1 Stock @ ₹1,000
  • Buy 1 Call Option @ ₹1,000 = ₹40 (Premium Paid)

Purpose: Creates the same risk/reward profile as buying a put.

6. Synthetic Short Put (Long Stock + Short Call)

• Structure:
  • Buy 1 Stock @ ₹ 1,000
  • Sell 1 Call Option @ ₹ 1,000 = ₹ 40 (Premium Received)

Purpose: Replicates the payoff of selling a put — limited upside, significant downside.

Advantages Of Synthetic Trading

• Capital Efficiency: Synthetic structures usually require lower margin than holding the stock outright. This can free up cash.
• Flexibility: You can construct tailored positions, long, short, protected based on your market view.
• Liquidity: F&O contracts, especially in index options (like NIFTY and BANKNIFTY), are highly liquid, making entry and exit easier.
• Hedging Capabilities: You can use synthetics to hedge portfolios or manage risk exposure more precisely.
• Cost Savings: Avoid delivery charges, taxes like STT on delivery-based trades, and demat-related expenses.

Risks & Considerations

Despite the benefits, synthetic trading involves risks:

• Margin Requirements: Although often lower, synthetic positions still attract margin obligations under SEBI regulations. For instance, short options require upfront SPAN + Exposure margins.
• Assignment Risk: In certain stock options, there is a possibility of early assignment on short positions, where the buyer may exercise the contract before expiry.
• Bid-Ask Spreads: In less liquid stocks, wide spreads can eat into your profits.
• Complexity: These are not beginner-friendly strategies. If you miscalculate, it could lead to losses.
• Implied Volatility Sensitivity: Option premiums change with volatility. Sudden shifts in implied volatility can impact payoff.

When Should You Use Synthetic Trading?

Synthetic trading strategies are not for every market condition. You should consider them:

• When you cannot or do not wish to hold physical stock
• If you're looking to create directional bets without capital-intensive positions
• To hedge a position without disturbing your portfolio
• When arbitrage opportunities arise between synthetic and actual prices
• To benefit from volatility mismatches

For example, if you're bullish on Reliance but the share price is at a resistance level, you might use a synthetic long to benefit from upside while reducing capital usage.

Step-by-Step Guide To Implement Synthetic Trading

1. Identify Your Objective
   Are you replicating a long position, short position, or hedging?
2. Select Underlying Asset
   Use highly liquid stocks or indices like NIFTY, BANKNIFTY, etc.
3. Choose the Right Strike Price & Expiry
   Match strikes for components in the synthetic position.
4. Check Margins
   Use NSE’s margin calculator to determine margin impact.
5. Execute Orders Carefully
   Simultaneously place orders, or use combo order facilities if available.
6. Monitor Position
   Track delta, gamma, and P&L regularly.
7. Exit or Adjust
   If markets move sharply, you may need to rebalance or exit.

Comparison Table Of Synthetic Strategies

Conclusion

Synthetic trading in F&O offers you a versatile and capital-efficient way to participate in the market. By constructing combinations of options and stocks, you can replicate positions without physically buying or selling the underlying. However, this approach is not without complexity. It demands a sound understanding of option mechanics, margin implications, and market conditions. If used wisely, synthetic market trading can be an effective tool for the experienced synthetic trader looking to optimise returns, reduce capital deployment, or hedge intelligently.

Also Read: Synthetic Call, Put & Long Combo: Strategy Guide