Using Synthetic Options in Equity Pairs Trading

Summary

This note considers replacing a long stock and short stock position in a pairs trade with synthetic option positions. It asks whether the synthetic exposure has the same risk and reward as holding the underlying shares directly. The response suggests that synthetics may be workable, while emphasizing practical tradeoffs rather than demonstrating exact equivalence.

A synthetic short may help when shares are difficult to borrow, and it can avoid directly handling dividend payments on a short stock position. However, options add transaction and commission costs, and their expiration creates a timing constraint. If the pair takes longer to converge than the option’s remaining life, the trader may need to roll or rebuild the position. The note gives no specific construction, pricing comparison, or analysis of financing, exercise, liquidity, and changing Greeks, so it is not enough to establish that synthetic and stock pairs have identical risk profiles.

Key ideas

• Synthetic options can be considered as substitutes for stock legs in a pairs trade.
• A synthetic position may provide short exposure when the stock is hard to borrow.
• Option-based exposure can avoid direct dividend handling on the short stock position.
• Trading costs and option expiration can make synthetics less convenient than stock positions.
• A pair that converges after expiration may require the trader to extend or replace the options.

Tags

# use synthetics for a pairs trading strategy


# use synthetics for a pairs trading strategy












Let us say I want to pursue a pair trading strategy between stock A(long) and stock B(short).

Can I replace this stocks with their synthetic option equivalents and have the same risk reward profile as if I had bought and shorted the actual underlying?

i.e Is the synthetic equivalent exactly equal to the underlying position?

## Answer by Rime (score 0, accepted)

https://quant.stackexchange.com/a/15581

This is very interesting. You probably can create synthetics for a pairs trading strategy however I believe that you need to consider the pros and cons.

Pros: 1. You can create a short position if the stock is hard to borrow. 2. You do not need to worry for dividend payments when shorting.

Cons; 1. It can be a bit expensive (transactions/commissions) 2. What expiration to use? What if you expect the pair to revert in 30-days but it doesn't actually do until 60?

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