Synthetic Arbitrage
Synthetic arbitrage is a trading strategy that exploits price discrepancies between synthetic and actual assets.
In financial markets, synthetic positions are created using derivatives such as options and futures to replicate the payoff of an actual asset.
The essence of synthetic arbitrage is to capitalize on the mispricing between the synthetic and the underlying real asset.
For example, if the synthetic version is more expensive than the asset in the cash market, they’d go short the synthetic version and long the cash market asset.
Key Takeaways – Synthetic Arbitrage
- Synthetic arbitrage involves creating a risk-free position by combining options and underlying assets.
- Traders can exploit price discrepancies between synthetic and actual positions to lock in profits.
- Monitoring synthetic versus actual prices is important to identify and execute arbitrage opportunities efficiently.
How Does Synthetic Arbitrage Work?
Synthetic arbitrage works by constructing synthetic positions that mirror the performance of an actual asset.
When the price of the synthetic position diverges from the price of the actual asset, traders can profit from this discrepancy.
The key is to simultaneously take opposite positions in the synthetic and the actual asset, locking in a risk-free profit as the prices converge.
Components of Synthetic Positions
- Options – Call and put options are essential in creating synthetic positions. A combination of these options can mimic the payoff of holding the actual asset.
- Futures – Futures contracts can also be used to create synthetic positions, especially when combined with options.
Let’s look at some examples of synthetic arbitrage trades:
Example 1: Synthetic Short Stock
Identify the Discrepancy
Suppose the stock of XYZ Corporation is trading at $100 in the market.
At the same time, the synthetic stock position created using options shows a different, higher value.
Create Synthetic Long Position
- Buy XYZ’s stock
- Short-sell a synthetic put
Arbitrage Opportunity
For example, if the call option costs $5 and the put option is sold for $4, the net cost of the synthetic position is $1 ($5 – $4).
Execute the Trade
- Sell 1 call option for $5
- Buy 1 put option for $4
Profit Realization
The total cost of the synthetic position is $1.
If the actual stock price is $100, buying the stock directly would cost $100.
The profit is $1 per share ($100 – $1) when the synthetic position converges with the actual stock price.
Special Note
Some synthetic short arb trades are simply equal to the risk-free rate, before considering transaction costs.
Be sure it’s a genuine arbitrage opportunity.
Example 2
Identify the Discrepancy
Assume the stock of ABC Company is trading at $150, while the synthetic stock position shows a different value.
Create Synthetic Short Position
- Sell a call option on ABC Company with a strike price of $150
- Buy a put option on ABC Company with the same strike price of $150
Arbitrage Opportunity
If the synthetic short position (sell call and buy put) can be created for a net credit higher than the current stock price, there is an arbitrage opportunity.
For instance, if the call option is sold for $10 and the put option is purchased for $8, the net credit is $2 ($10 – $8).
Execute the Trade
- Sell 1 call option for $10
- Buy 1 put option for $8
Profit Realization
The net credit from the synthetic short position is $2.
If the actual stock price is $150, short selling the stock directly would cost $150.
The profit is $2 per share when the synthetic position converges with the actual stock price.
Key Considerations for Successful Synthetic Arbitrage
- Liquidity – Verify that the options and underlying assets are liquid to facilitate the smooth execution of trades.
- Transaction Costs – Be sure that the profit from the arbitrage opportunity exceeds any transaction costs involved in executing the trades.
- Market Conditions – Monitor markets to manage the risks and that the price discrepancies converge as expected.
- Risk Management – Manage and adjust positions to reduce potential risks arising from adverse market movements.