How are Synthetic Shares created?

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How are Synthetic Shares created?

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Answer 1

Imagine you want to buy a stock, but you don’t want to actually *buy* the stock. Maybe you have your money tied up in a term deposit, or you don’t want to cut into your emergency savings, or you’re currently invested in a stock with a good dividend that you don’t want to sell – whatever the case, you want the financial risks and benefits of owning a certain stock for $50 without actually paying $50 *right this second*. What do you do?

Well, you recreate the risk and return of the stock using options.

If you buy the stock for $50 today, and it goes up in price to $60 in a month, you’ll make $10, right? Well, another way to make $10 on that stock is to buy a call option with a strike price of $50 that expires in one month. If the stock goes up to $60, you exercise the option and make $10.

On its own, that seems great – why even worry about the downside? You can just buy call options with no downside risk!

Well, options cost money. Not as much as spending $50 on the stock, sure, but enough to impact your returns at the end of the day. How do you offset this cost while maintaining the risk profile of owning the actual stock?

You sell a put option! If you sell a put option with a strike price of $50, you’re selling someone the option of selling you the stock for $50. If the stock price drops to $40, you’re still stuck buying the stock for $50, and you lose $10. It sounds an awful lot like owning the stock, right?

These two options should more or less cancel each other out – you pay money for the call option, receive money for the put option, and end up with a position that mimics the return of the underlying stock. That’s what the synthetic share is – a position that mimics the returns of the underlying share.

You can have other synthetic positions, too – the basic idea is that a synthetic position is created by combining financial instruments to mimic the returns of some other financial instrument. I can get into those if you’d like, but the overall concept is the same!