Compared with margin or swap financing a long position, or borrowing securities to sell short, equivalent long or short exposures to many top European stocks can be implemented with an options-based “synthetic forward” strategy. This article explains how to trade a synthetic forward, and some of the advantages of financing or shorting a stock using a synthetic forward rather than through a physical stock trade.

A synthetic forward long position on a stock is one where you are long a call and short a put on the same stock, where the call and put have the same expiry date and strike price. This combination of options has a delta of one, and zero gamma, or in other words, exposure to the ups and downs of the underlying stock very close to simply owning the stock directly, without having to fully finance a long physical stock position. Similarly, you can synthetically short a stock by buying a put and selling a naked call on that stock, again with the same strike prices and expiry dates on the put and the call. These two options in the synthetic short combine to having a delta of negative one, and zero gamma.

Three main advantages institutional investors might see in synthetic forwards are better financing costs, the ability to lock in those costs over the term of a trade, and protection from being forced out of a short position. To illustrate these examples, consider the following synthetic forward trades on a hypothetical stock currently trading at €100 per share, on which we are considering either a long or short position over the next three months, and the stock is expected to pay a €1/share dividend next month.

Physical vs Synthetic Longs

For a physical long position of 100 shares, we would need to finance €10,000, either through opportunity cost, or by borrowing on margin or through swap financing. At the time of this writing, the three-month €STR swap benchmark is right around 3%, so the interest cost of financing €10,000 for three months would be around €75 for an institution with a flat financing cost, versus around €100 for an institution financing at 100bps over the benchmark. 

Over that three-month trade term, you would also expect to receive a €100 dividend from this stock position, gross of any taxes that might be withheld or otherwise owed on this stock. With these assumptions, the net carrying cost of this position would net to slightly more than or less than zero depending on your financing costs and dividend tax rate. On the other hand, a three-month synthetic forward with a strike price of 100 and assuming a flat 3% implied interest rate and zero implied withholding tax rate would trade at a €25 credit to the trader putting on a long position.[HR1]  Ideally, traders should have a calculator handy to compare the net financing costs of physical versus synthetic long positions side by side.

Physical vs Synthetic Shorts

Similar math applies to a short position on 100 shares, which if done physically would require borrowing those 100 shares against around €10,000 of collateral. Putting on the short position synthetically would mean paying the €25 net debit cost of the options described above, so if the net borrow cost of the shares is more than €25 over the term of the trade, then the synthetic forward would be more cost effective than borrowing shares to sell them short.

The Fixed Cost Advantage

It is worth repeating that in addition to the net carrying costs of a synthetic position possibly being more favorable than a physical long or short position, that the synthetic forward also locks in these costs for the entire term of the trade. This can be especially useful for short positions, where not only is the borrowing cost locked in, but the position is protected against the risk of borrowed shares being called back from the short seller.

Operationally, there is also the advantage that all of these costs are priced up-front and can be accounted for on only two dates: the date the synthetic forward is entered, and the date the position expires or is unwound. Having to administer and account for cash flows from financing or dividends on physical stock positions is sidestepped when these positions are traded synthetically.

Conclusions

 Synthetic forwards are a very similar “delta one” position that may reduce costs, taxes, and risks on both long and short positions over a pre-defined time horizon. The next time you are considering financing a long position or borrowing shares to sell short, it is worth comparing the total cost and risk of doing so physically versus via synthetic forwards. 

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·      The above is the product of external market analysis commissioned on behalf of Cboe Europe B.V. The views expressed herein are those of the author and do not necessarily reflect the views of Cboe Europe B.V., Cboe Global Markets, Inc. or any of its affiliates (‘Cboe’). For more information on how this research was conducted and/or the author please contact [email protected]

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