Here we’ll discuss what the difference between real stock and synthetic stock is, the pros and cons of each, and where the future lies for this type of investing.
In Investing, what is Synthetic Stock?
Synthetic stock is an asset generated by combining many existing asset types. A synthetic stock position is a derivative transaction that mimics a cash or spot position.
Typically, the equity options market is utilized to establish synthetic stock positions, the most prevalent form of which is produced using exchange-traded common options.
Various combinations of puts and calls allow for the creation of synthetic long and short stock positions. These positions mirror the profit and loss situations associated with stock ownership.
The long synthetic stock position is established by purchasing call options and selling put options. Both the call and put must have the same strike price and expiry date.
At the money (ATM) options should have a delta close to plus or minus 0.50, with the end position delta equal to zero. The potential cost of this transaction is $0, but the broker will keep sufficient cash to cover the executed short option position.
Purchasing a put and selling a call creates short synthetic situations. The same rules apply to both the option’s expiry date and its strike price. Delta 0.50 puts and calls are always ATM options, meaning the strike price is extremely near to the underlying stock’s real cash value.
This transaction will result in a tiny debit or credit to the account, but does not include broker fees. The broker will always maintain sufficient cash to cover the possibility that the short option will be executed.
One option contract corresponds to 100 shares of the underlying stock, since option contracts are sized in lots of 100 shares. When an investor opens a long or short synthetic stock position, he or she will control 100 shares each contract. Theoretically, the investor will earn the same profit or loss as a long or short cash position in the company.
Advantages of Synthetic Stock
The benefit of synthetic positions is the opportunity to generate returns with a lesser initial commitment than if the stock were purchased outright. The investor is also responsible for losses if the stock’s price declines.
A further advantage of the synthetic short position is the ability to short sell a stock independent of short sale regulations. The expiry of synthetic positions’ contracts is a disadvantage.
Synthetic stock positions can be used as part of a complex trading strategy. The investor who has dividend-paying stock may anticipate a broad downturn in the market. Instead of selling the income-generating portfolio, the trader may elect to establish a synthetic position as a hedge.
This would allow the trader to benefit from the ongoing dividend payments while avoiding capital losses caused by the stock’s depreciation.
On the basis of the synthetic stock position, several innovative option trades may be executed. If market circumstances alter, the investor might at any moment add another option transaction to the synthetic position.
Additionally, the investor might shut out one leg of the trade to create a straightforward option position. Option trading offers the investor the opportunity to construct new and intriguing stock market positions.
How Synthetic Stock Work?
Similar to derivatives in conventional finance, synthetic assets are digital assets whose prices are tied to the prices of other real-world assets, such as TSLA or AAPL. These assets, sometimes known as “synths,” give the returns of conventional assets without needing access to the actual item.
Due to the fact that synthetic stocks are derivatives, their value is generated from an underlying asset through smart contracts. Therefore, these assets may be used to trade the price and value fluctuations of conventional assets.
Typically, synthetic assets are developed as ERC-20 smart contracts that operate on the Ethereum blockchain. They vary from options and other conventional kinds of derivatives in that they tokenize the link between the derivative and the underlying asset.
In contrast, classic derivatives are financial contracts that determine the terms and price of an item. This enables DeFi customers to use synthetic assets with a variety of trading methods. By placing positions in derivatives, hedging, a common method in binary options trading, enables players to balance losses and minimize risks. In DeFi’s universe of synthetic assets, such tactics are also used.
A synthetic stock is generated when the holder of a call and put option buys and sells the options accordingly to imitate the stock. Despite not engaging in the market, the holder stands to profit. Then, as long as the options have not yet expired, they can invest in the stock.
Synthetic Stock may be formed in a variety of methods, but the most typical entail taking a long or short stand on a put or call option, respectively. An investor will take a long position on the call option and a short position on the put option to create a synthetic long stock. The other posture is referred to as a synthetic short stock.
This requires the investor to hold a long position in put options and a short position in call options.