Introduction
This trading strategy in the Indian stock market—known as "synthetic futures"—enables an investor to put together options that would very nearly replicate the risks and rewards of a traditional futures position. Such an approach will turn out to be quite useful for traders who are looking for the same kind of exposure but with added flexibility, or maybe in cases where they would not get direct access to futures contracts.
> Understanding Synthetic Futures in the Indian Stock Market
Basic Concept:
Synthetic futures are a futures position replicated with options. This generally comprises a long call option and a short put option, or vice versa.
Replicating Nifty Futures with Options:
Take the case of the Nifty index. Instead of buying or selling Nifty futures contracts outright, a trader may have to take a synthetic futures position using options.
Example with Nifty Index:
Rather than buying or selling Nifty futures, which is an expensive business, a trader can use one interesting strategy known as Synthetic Futures using options.
Now, in Nifty land, this is like a superhero power—tells you how much your investment will go up if Nifty moves by 1 point. The delta for Nifty futures is always 1, but that too takes a lot of money!
So, consider this: the At the Money Strike of Nifty comes with a Delta of 0.5. A clever trader can buy two lots of these ATM options and, just like that, their net or total Delta becomes 1.
Here's the math: Say ATM nifty strike costs about 150 rupees. Now, for two lots, he just needs to invest 15,000 rupees. It is much less than the 1.5 lakhs required for regular futures. And guess what? It's called Synthetic Futures.
But, let's get real. There's a catch. In case Nifty plunges by the expiration date, our trader stands to lose 15,000 rupees. Ouch! Unlike with futures, where you roll it over for the next month, in Synthetic Futures, you're kinda stuck.
Now, Synthetic Futures is like a money-saving trick for traders. The profit potential is exactly like that of a regular futures position; however, it comes at a much lower upfront cost. Just watch out for that potential loss if Nifty doesn't play nice!
The other ways of using Synthetic Futures with Options are as follows:
Long Synthetic Futures Position:
Buy a Nifty call option.
Sell a Nifty put option simultaneously.
Short Synthetic Futures Position:
Sell a Nifty call option.
Buy a Nifty put option.
> Risk and Reward:
Long Synthetic Futures:
Profit: When the Nifty index goes up.
Loss: Both call and put premiums add up to this loss.
Short Synthetic Futures:
Profit: When the Nifty index goes down.
Loss: The combined premium paid for the call and put options limits this loss.
> Advantages of Synthetic Futures in the Indian Context:
Flexibility: Investors can take exposure to the Nifty index without directly going into futures trading.
Cost Efficiency: Compared to futures contracts, options are less capital intensive.
Risk Management: Since the risk involved is known and fixed, it is suitable for risk-averse traders.
> When to Use Synthetic Futures in the Indian Stock Market:
Restricted Futures Access: When some investors have limited access to trading futures.
Customized Exposure: When one wants tailored exposure to the market.
Example of Nifty:
Suppose the underlying Nifty index is at 15,000. A trader bearish in the index:
Buy a Nifty call option, say with a strike price of 15,200.
Sell a Nifty put option with a strike price of 14,800.
It creates a synthetic long Nifty futures position. If the Nifty rises, the value of the call option increases, which offsets the loss in the put option.
> How to Create Synthetic Futures Position
Now, let me break down in simple words how one constructs a Synthetic Futures position, step-by-step, by way of an example taken for the Nifty index.
1. The Basics:
Synthetic Futures replicate the profit and loss of actual futures, but here in this case, it is replicated with options.
We generally take a call and put option in a synthetic position for the Nifty.
2. Choosaour View:
Decof ide whether you are Bullish—that is, Nifty will go up—or Bearish—that is, it will go down.
3. Bullish View: Nifty Going Up
Buy Call Option: This gives you the right to buy Nifty at a particular price.
Sell Put Option: You are ready to buy Nifty at another particular price.
Illustration: (30 Nov 2023 Expiry)
Nifty is at 19,450.
Buy Call Option with strike price 19,650.
Sell a Put Option with the strike price of 19,250 simultaneously.
PAYOFF GRAPH will look like this
4. For a Bearish View: Nifty Going Down
Sell a Call Option: You promise to sell Nifty to someone at a certain price.
Buy a Put Option: This gives you the right to sell Nifty at another price.
Example: (30 Nov 2023 Expiry)
Nifty is at 19,400.
Sell a Call Option with strike price 19,650.
Along with this sell a Put Option with strike price 19,450.
PAYOFF GRAPH will be like this
5. Investment Comparison:
In the traditional sense Nifty Futures, may require 1.5 lakhs for one lot.
Synthetic Futures with options may require only, say 15,000 rupees
As I already explained above with proper examples.
6. Risk Awareness:
Be aware that in case Nifty does not move your way, you may incur losses. In our case, it is restricted at what you invested.
Creating a Synthetic Futures position costs about the same as customizing your investment to your market view but at a much more affordable price tag. Just remember that, like any other investment, there are inherent risks involved.
> When to Use Synthetic Futures
1. Limited Access to Futures:
Scenario: You are a retail trader or generally have limited access to trading traditional futures contracts.
Why Synthetic Futures: The alternative way to take a view on market movements does not require huge upfront capital.
2. Cost Efficiency:
Scenario: You think it takes too much capital to trade futures directly.
Why Synthetic Futures: By using options, one can obtain an identical synthetic position for only a fraction of the upfront cost required for traditional futures.
3. Customized Exposure to the Markets:
Scenario: When you have a certain view on a specific market or would like to adjust your exposure to price movements.
Why Trade Synthetic Futures: It brings flexibility. Depending on your view—bullish or bearish—you can create a synthetic position that is oriented that way using call and put options.
4. Risk Management:
Scenario: When you want to control and limit your possible losses.
Why Synthetic Futures: Options, by definition, have a naturally limited risk because your loss is constrained in advance to be no more than the premium you pay. This can be very attractive to more conservative traders who want to involve the market with a predefined level of risk.
5. Portfolio Diversification:
Scenario: Suppose you want to diversify your investment portfolio.
Why Synthetic Futures: Synthetic positions can add great value to a diversified portfolio, allowing you to enforce diversity into your strategy and ultimately take advantage of various market conditions without relying on the pure trading of futures.
Therefore, synthetic futures on the Indian stock market and about indices such as Nifty offer a useful and more variable solution in comparison with normal futures. Options can be used smartly to position a particular outlook about the market expectations, given the freedom and the hedging opportunity this tool provides. Again, special precautions, as usual, have to be taken by traders while observing market conditions and when deciding on the capacity to bear risk before adopting synthetic futures strategies.