InvestorQ : Is it possible to replicate Short futures positions as options and just pay premium?
Swati Naik made post

Is it possible to replicate Short futures positions as options and just pay premium?

Answer
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Ria Roy answered.
2 years ago


You can use option synthetics and create a situation similar to short futures too. These are called synthetics. Here, you do not take a futures position but you replicate it with an options position with similar payoffs. A very common synthetic is to replicate a futures position by buying a put option and simultaneously selling a call option. Let us look at the chart below to understand how this synthetic works in practice.

Sell Nifty Futures 10,600 and Replicate with Buying 10,600 Put at Rs.20 Plus selling a 10600 call at Rs.20

Short Nifty Futures

Nifty Spot

Futures P/L

Buy Put Strike

Premium Paid

OTM/ITM

Put P/L

Sell Call Strike

Prem Recd.

OTM/ITM

Put P/L

Synthetic Profit

10600

10000

600

10600

-20

ITM

580

10600

20

OTM

20

600

10600

10050

550

10600

-20

ITM

530

10600

20

OTM

20

550

10600

10100

500

10600

-20

ITM

480

10600

20

OTM

20

500

10600

10150

450

10600

-20

ITM

430

10600

20

OTM

20

450

10600

10200

400

10600

-20

ITM

380

10600

20

OTM

20

400

10600

10250

350

10600

-20

ITM

330

10600

20

OTM

20

350

10600

10300

300

10600

-20

ITM

280

10600

20

OTM

20

300

10600

10350

250

10600

-20

ITM

230

10600

20

OTM

20

250

10600

10400

200

10600

-20

ITM

180

10600

20

OTM

20

200

10600

10450

150

10600

-20

ITM

130

10600

20

OTM

20

150

10600

10500

100

10600

-20

ITM

80

10600

20

OTM

20

100

10600

10550

50

10600

-20

ITM

30

10600

20

OTM

20

50

10600

10600

0

10600

-20

ATM

-20

10600

20

ATM

20

0

10600

10650

-50

10600

-20

OTM

-20

10600

20

ITM

-30

-50

10600

10700

-100

10600

-20

OTM

-20

10600

20

ITM

-80

-100

10600

10750

-150

10600

-20

OTM

-20

10600

20

ITM

-130

-150

10600

10800

-200

10600

-20

OTM

-20

10600

20

ITM

-180

-200

10600

10850

-250

10600

-20

OTM

-20

10600

20

ITM

-230

-250

10600

10900

-300

10600

-20

OTM

-20

10600

20

ITM

-280

-300

10600

10950

-350

10600

-20

OTM

-20

10600

20

ITM

-330

-350

10600

11000

-400

10600

-20

OTM

-20

10600

20

ITM

-380

-400

10600

11050

-450

10600

-20

OTM

-20

10600

20

ITM

-430

-450

10600

11100

-500

10600

-20

OTM

-20

10600

20

ITM

-480

-500

10600

11150

-550

10600

-20

OTM

-20

10600

20

ITM

-530

-550

10600

11200

-600

10600

-20

OTM

-20

10600

20

ITM

-580

-600

10600

11250

-650

10600

-20

OTM

-20

10600

20

ITM

-630

-650

10600

11300

-700

10600

-20

OTM

-20

10600

20

ITM

-680

-700

10600

11350

-750

10600

-20

OTM

-20

10600

20

ITM

-730

-750

10600

11400

-800

10600

-20

OTM

-20

10600

20

ITM

-780

-800

10600

11450

-850

10600

-20

OTM

-20

10600

20

ITM

-830

-850

10600

11500

-900

10600

-20

OTM

-20

10600

20

ITM

-880

-900

The above is a very classic example of a synthetic position where we have tried to create a short futures position by replicating it with (long put + short call). The left side pink shaded portion is the short futures position. You can see that the futures profits are linear and the losses and the profits move with the stock price. We are replicating the futures with a synthetic position marked in yellow colour, which is a combination of a long put option and a short call option. If you see the payoffs of the long futures position and the synthetic position, you will find that the cash flow profile is almost the same. The payoff profile is a carbon copy of the short futures and the synthetic position because we have bought the put and also sold the call at the same strike and the same premium as the short futures.

This is a perfect situation that rarely exists in practice. When do you use such synthetics? When you find that the payoff of a synthetic position is better than a pure futures position then you can look at a synthetic position which combines a put and call. When the synthetic position is perfectly like futures then you are indifferent between futures and synthetics. It is only when there is gap and it is favourable that you would opt for the synthetic position. In fact, these are the opportunities wherein a synthetic becomes more meaningful. There are also high volume traders who do arbitrage between pure futures and synthetics when there is pricing differential. But that is something we will leave aside for now!