In the world of stock trading, a synthetic cross-pair is a pair of stocks that have no direct correlation to their price movements. In effect, these two securities are created from the combination of multiple other securities.
One method for creating a synthetic cross-pair involves buying an out-of-the-money call option on one security and simultaneously selling an out-of-the-money put option on its matching security with both options expiring simultaneously.
If done correctly, this will eliminate any directional risk taken by either party and reduce costs through option premium income from both directions.
How to Build a Synthetic Cross-Pair
Determine an Underlying Stock Pair to Build Upon
First, you must choose what securities will make up the synthetic cross-pair. You can do it by picking two different stocks or different types of options on the same stock (like a put and call option). These two securities must have little to no direct correlation for this technique to work correctly.
Calculate Call Option Strike Price and Put Option Strike Price
The next step is to determine the strike price for both the call option and the put option that is being bought. The difference between these two prices should be substantial enough to yield a sizable potential reward should one of them close in the money at expiration while limiting any loss should neither finish in the money. You may use an option calculator for this if you are unsure of the strike prices to choose on your own.
Calculate Option Premiums
Calculating how much each leg should cost is a matter of first obtaining a call option and putting option quotes for the same security with the exact expiration dates, then picking strike prices that are roughly equal given that they are out-of-the-money. It will create a trade with no directional risk despite being two separate trades as long as both legs are closed at expiration.
Now buy the call option on one security while simultaneously selling the put option on its matching security, ensuring that both options have the same expiration date. This long call/short put combo will eliminate directional risk from either party and create cash flow with both premiums in effect.
How to Trade a Synthetic Cross-Pair
Check Last Price of Underlying Stocks
First, check the last price of both the call option and put option that you previously bought or sold. If one is trading for much more than the other, it’s a good idea to close out these positions now before they create losses on their own.
You can do this by selling your call option to increase in value much more than your put contract. Conversely, sell your put contract if it has decreased in value much more than your call contract.
Evaluate Risk/Reward of Options at Expiration
Depending on where each leg is currently trading relative to its strike price, you may wish to buy back either option early for instant free cash, especially if you feel the underlying security will make a strong move in either direction. You wish to be exposed to that movement.
Enter or Exit Your Synthetic Cross-Pair Position
If both legs of your trade are currently out-of-the-money, you can allow them both to expire and close the position entirely. It will create an overall cash credit which you can take as profit. Then, new options can be traded on this same security pair once again if desired. However, suppose one leg of the trade has finished in the money while the other is still out-of-the-money at expiration.
In that case, it often makes more sense to exercise the option with the higher value and sell it for its intrinsic value rather than let it expire. It will allow you to close out the position entirely for an overall gain, creating immediate risk-free cash flow in the process.
Repeat Cross-Pair Trades as Desired
With synthetic cross-pairing, you can effectively create short premium trades that provide limited directional exposure and limited risk potential with little difficulty. Note that this is not a free lunch; each leg has its margin requirement, so always trade responsibly to avoid unnecessary losses.
Why not try and use synthetic cross-pairing when you trade forex online?