Risk Reversals and Synthetic Positions
Risk Reversals and Synthetic Positions
Risk reversals and synthetic positions use options to replicate or approximate the behavior of stock ownership. Understanding these structures reveals how options pricing reflects market sentiment and provides alternative ways to gain directional exposure with different capital requirements and risk profiles.
Definition and Key Concepts
Synthetic Long Stock
A synthetic long stock position replicates owning 100 shares by combining:
- Long 1 ATM call
- Short 1 ATM put (same strike and expiration)
The combined position has delta of approximately 1.00 and behaves like stock.
Synthetic Short Stock
A synthetic short stock position replicates being short 100 shares:
- Short 1 ATM call
- Long 1 ATM put (same strike and expiration)
The combined position has delta of approximately -1.00.
Risk Reversal
A risk reversal uses options at different strikes:
- Long OTM call
- Short OTM put (or vice versa)
This creates directional exposure while often achieving near-zero cost. It also serves as a sentiment indicator in currency and commodity markets.
Position Comparison
| Position | Construction | Delta | Initial Cost |
|---|---|---|---|
| Stock | Buy 100 shares | +100 | Full stock price |
| Synthetic long | Long call + short put (ATM) | ~+100 | Near zero |
| Risk reversal (bullish) | Long OTM call + short OTM put | +50 to +80 | Near zero |
How It Works in Practice
Synthetic Long Stock Mechanics
Example: XYZ trades at $50.
Trade:
- Buy 1 XYZ $50 call for $2.50
- Sell 1 XYZ $50 put for $2.25
- Net debit: $0.25
Greeks:
- Delta: +0.52 (call) + 0.48 (short put reverses to positive) = +1.00
- Theta: -$0.03 (call) + $0.03 (short put) = ~$0
- Vega: +$0.08 (call) - $0.08 (short put) = ~$0
Payoff Comparison:
| XYZ at Expiration | Stock P/L | Synthetic P/L |
|---|---|---|
| $45 | -$500 | -$500 - $25 = -$525 |
| $50 | $0 | -$25 |
| $55 | +$500 | +$500 - $25 = +$475 |
The synthetic tracks stock closely, with small differences from the initial debit and any IV changes during the holding period.
Why Use Synthetics?
Capital Efficiency: Buying stock requires $5,000. The synthetic requires only margin on the short put (typically 20% of strike = $1,000 or less), freeing capital for other uses.
Flexibility: Synthetics can be adjusted by closing one leg, converting to a spread, or rolling.
Dividend Considerations: Synthetic long holders don't receive dividends. The put premium typically reflects expected dividends, making synthetics less attractive for high-dividend stocks.
Risk Reversal for Directional Exposure
Example: You're bullish on ABC ($100) but want lower cost than buying calls.
Trade:
- Buy 1 ABC $110 call for $2.00
- Sell 1 ABC $90 put for $1.75
- Net debit: $0.25
Greeks:
- Delta: +0.30 (call) + 0.25 (short put) = +0.55
- Max profit: Unlimited (above $110)
- Max loss: $90 × 100 - $0.25 × 100 = $8,975 (if ABC goes to zero)
Breakeven:
- Upside: $110 + $0.25 = $110.25
- Downside: Below $90, you're assigned and own stock at $90
Worked Example
Synthetic vs. Stock: Full Comparison
You have $10,000 and want bullish exposure to XYZ at $50.
Option 1: Buy Stock
- Buy 200 shares at $50 = $10,000
- Delta: +200
Option 2: Synthetic Long
- 2 synthetic positions (2 calls, 2 short puts at $50)
- Margin required: ~$2,000
- Delta: +200
- Cash remaining: ~$8,000 (can earn interest or deploy elsewhere)
Option 3: Risk Reversal
- Buy 2 $55 calls for $1.50 ($300)
- Sell 2 $45 puts for $1.25 ($250 received)
- Net debit: $50
- Delta: ~+100
- Cash remaining: ~$9,950
Outcome Comparison (XYZ at $60):
| Strategy | Gain | Return on Capital |
|---|---|---|
| Stock (200 shares) | $2,000 | 20% |
| Synthetic (2 positions) | $1,950 | 98% (on $2,000 margin) |
| Risk reversal | $750 | 1,500% (on $50 debit) |
Outcome Comparison (XYZ at $40):
| Strategy | Loss | Notes |
|---|---|---|
| Stock (200 shares) | -$2,000 | Paper loss |
| Synthetic (2 positions) | -$2,050 | Plus short put assignment |
| Risk reversal | -$1,050 | Assigned at $45, stock now $40 |
The risk reversal has asymmetric risk—participates fully above $55 but still has substantial downside from the short put.
Risks, Limitations, and Tradeoffs
Assignment Risk on Short Puts
Synthetic longs and risk reversals include short puts that can be assigned, requiring cash to purchase shares. Ensure you have capital available for this obligation.
Dividend Exclusion
Synthetic long holders don't receive dividends. For stocks with significant dividends, actual stock ownership may be preferable.
Margin Requirements
While capital efficient, short puts require margin. In volatile markets, margin requirements can increase unexpectedly.
Early Assignment
American-style short options can be assigned early. Deep ITM puts may be assigned before anticipated, disrupting the strategy.
Common Pitfalls
-
Ignoring dividend impact: Synthetics underperform dividend-paying stocks during ex-dates.
-
Underestimating put assignment: Being assigned creates stock ownership with its own capital requirements.
-
Overleveraging: Just because you can control more delta with less capital doesn't mean you should.
-
Forgetting about rho: Synthetics have interest rate sensitivity from the put-call parity relationship.
-
Not monitoring margin: Rising volatility increases margin requirements on short puts.
Checklist for Synthetic Positions
- Compare synthetic cost to direct stock purchase
- Account for dividends if applicable
- Calculate margin requirements for short put
- Verify you can cover assignment if put goes ITM
- Set the same stop-loss rules as you would for stock
- Monitor delta to confirm it matches stock behavior
- Consider rolling or adjusting as expiration approaches
- Track net theta and vega to ensure they remain near neutral
Next Steps
For a comprehensive reference of options terminology covered in this section, see Glossary: Options Strategy Terms.
For income-oriented calendar structures, review Calendar Spreads for Income Generation.