Long and Short Stock Positions Using Synthetic Forwards

As a retail investor, the relatively high cost of margin borrowing makes it very expensive and difficult to profitably leverage long positions. Similarly, individual investors often face high short selling costs, which makes it expensive and difficult to profit from a stock going down, even when you are right. This article explains the strategy of the “synthetic forward”. Where even as a retail investor, you can access institutional-level rates on short and leveraged long positions on many European stocks. In this article, we briefly explain how to trade a long and short synthetic forward, then outline some of the main risks.

Synthetic Forwards: Long and Short

A synthetic forward long position on a stock is one where you buy a call and sell a put on that same stock, where the call and put have the same expiry date and strike price. This combination of options adds up to practically identical exposure to simply owning the stock directly, meaning you make €1/share when the stock goes up, and lose €1/share when the stock goes down. However, with a synthetic forward, you do this without having to put down the full cost of the shares in cash, or having to implicitly borrow the shares. Rather, you simply need to have enough capital in your account to meet the margin requirement of the put option you are selling.

Similarly, you can synthetically short a stock by buying a put and selling a naked call on that same stock, again with the same strike prices and expiry dates on the put and the call. These two options provide practically identical 1:1 exposure as selling the stock short, that is, you make €1/share when the stock goes down, and lose €1/share when the stock goes up. However, with a synthetic forward, you enter this short position without having to borrow any shares to sell short, but rather, by simply having to have enough capital in your account to meet the margin requirement of the short naked call position.

With a synthetic long position, your maximum loss is the same as if you purchased the same number of shares physically, meaning that if you buy a synthetic forward on one option contract (100 shares) of a stock currently trading at €100/share, your maximum loss would be 100 x €100, or €10,000, if that stock were to go to zero. If you had less than €10,000 of capital in your account, you may be subject to a margin call and forced to liquidate your position at a significant or even total loss even without the stock going to zero, and may be locked into such a loss even if the stock later recovers. Conversely, with a synthetic short position, your maximum loss is theoretically unlimited, as there is no fixed limit to how much a stock can rise, and the short position loses you €1/share of the stock’s rise whether you short a stock physically or via synthetic forward.

Cost Advantages

As of this writing, the 3-month Euro benchmark interest rate is around 3%, while many major European brokerage firms are advertising margin rates of 5-6%. Suppose you wanted to lever up a position of a stock currently trading at €100/share, using €10,000 of your own money, and then borrowing another €10,000 on margin from your broker to buy a total of 200 shares. If your broker charges you 6% interest on that margin loan, this trade would cost you €150 of margin interest over a 3-month period. By contrast, assuming this stock is not expected to pay a dividend over the next 3 months, the net cost of buying a 100 strike call and selling a 100 strike put with a 3 month expiry is likely to be closer to 0.75 per share or €75 total, equivalent to the cost of taking a margin loan at the benchmark 3% interest rate. This synthetic forward can be used instead of taking out a margin loan to finance the additional €10,000 of shares you wanted to buy, or you could trade two synthetic forwards to gain exposure to all 200 shares and keep most of your own €10,000 capital free for other trades. 

Similarly, if you wanted to short 100 shares of the same stock, your broker would charge you a borrowing cost on the shares you borrow to sell short, and European brokers are currently advertising rates of 1-3% per year to borrow many major stocks. On the other hand, if you were to simply sell the synthetic forward described above, by selling the 3-month 100-strike naked call and buying the 100-strike put on a stock not expected to pay dividends in the next 3 months, then you would expect to receive around €75 per 100-share lot for putting the trade on.

Note that these illustrations only look at relative borrowing costs, and do not consider the differences in trading costs your broker may charge for stock trades versus option trades.

Possible Tax Advantages

While this article is not meant to give tax advice, it is worth noting a key difference between physically long a stock versus via a synthetic forward while that stock pays out a dividend. If you hold 100 shares of a stock that pays out a €1/share dividend, or €100 gross, depending on where that company is based, up to 35% of that €100 might be withheld by the country of origin as a withholding tax, and you will then need to reconcile this with any taxes on dividends charged by your country of residence. On the other hand, if you hold your exposure to those 100 shares through a long synthetic forward, the value of expected dividends is priced into the synthetic forward when you buy it. For example, using the same 3% interest rate assumption, and assuming that €100 stock is expected to pay that €1/share dividend within the next 3 months, we might expect that 3-month synthetic forward to have a net price that pays the buyer €0-25 to account for the dividend, as opposed to the non-dividend version above for which the buyer would have to pay €75. Traders should compare the net after-tax impact of capturing the effect of the dividend via synthetic forward like this as a capital gain, versus tax impact of receiving the dividend in cash from physically owning the stock.

The Clarity Advantage

A third advantage of synthetic forwards, though less quantifiable, is their simplicity. With a synthetic forward, you do one trade to enter the synthetic forward, and then your entire profit or loss is simply the difference between that entry price and the value of the forward when it expires or when you unwind it. There are no intermediate interest or dividend cash flows to worry about or account for, and no worries about your broker calling back the shares you borrowed in the middle of a short sale. In other words, the synthetic forward is a clean and simple way of putting on a long or short position over a pre-defined period of time with pre-defined economics.

Conclusions

Synthetic forwards are a way to get the same 1:1 exposure of a long or short stock position, but are done using options rather than by financing and trading physical shares. Advantages of synthetic forwards include likely better financing or short-selling rates than many brokers charge retail investors, and possibly cleaner tax treatment depending on your country of residence. Consider these costs and risks carefully when deciding whether to put on your next stock trade directly versus with synthetic forwards.

Learn more

Visit Cboe’s Options Institute to explore the basics of options trading, here.

Cboe Europe offers trading in shares from across Europe and, through Cboe Europe Derivatives (CEDX), options are also available on shares in close to 300 leading European companies. Learn more about CEDX here.

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