Hi All, I'm new to trading and won't be starting my first trade for probably another 6-9 months or so but am trying to grasp a few things. I was reading about all of the different types of traders on investopedia and came across "Detrimental Traders" and they were speaking of Arbitraguers. They said this about them: Liquidity risk - Arbitrage trades are necessarily synthetic, leveraged trades, as they involve a short position. If the assets used are not identical (so a price divergence makes the trade temporarily lose money), or the margin treatment is not identical, and the trader is accordingly required to post margin (faces a margin call), the trader may run out of capital (if they run out of cash and cannot borrow more) and be forced to sell these assets at a loss even though the trades may be expected to ultimately make money. In effect, arbitrage traders synthesize a put option on their ability to finance themselves. Can you please tell me: What exactly is a synthetic trade? I have looked it up and the definition was: "A financial instrument that is created artificially by simulating another instrument with the combined features of a collection of other assets. " What does that MEAN? Thanks in advance!
to Ron Jon: I will give concrete example. If we write (sell) 60 Call Sep14 VTR and buy 60 Put Sep14 Call VTR, then this is called synthetic short VTR stock position. Risk graf will be basicaly same as shorting VTR itself.
Many reasons. To short against the box in a combo dated in a later tax year. To short stock where no natural shares can be borrowed. To effect a conversion, box or roll arbitrage.
Say you are sitting on large profits in 2014 and you want to (illegally) defer some of those gains to 2016. You're long shares and you sell a Jan 2016 synthetic. You sell a call and buy the same-strike put. The margin req on this conversion under RegT is roughly 1/4 of the cost to carry the naked-long and you're risk-free*. *rate risk. assignment. IRS.