When options strategists create a combination position, they do so by using three distinct components: Calls, puts and the underlying asset. Each of these financial instruments has its own unique risk-to-reward performance graph. A trader may enter and exit a long or short position in any of them without involving the other two pieces. However, each of these instruments is connected to the others.

By correctly combining any two of these instruments, the strategist can create a combination position that mimics the risk-to-reward profile of the third. These types of combination positions are known as synthetics.

Understanding how the three components are related is useful because traders can use the knowledge to change an existing position without liquidating it. For definitional purposes, a synthetic position is an options strategy involving two or more instruments that has the same risk-to-reward profile as a strategy involving only one instrument.

When first trying to analyze combination positions, you might think it's easiest to look at the three components separately. But, eventually it becomes impossible to study the profit and loss characteristics of one without noticing some similarities and differences when you look at it in comparison to the other two. This is because all three share a common element, which is the underlying stock, and, consequently, they are closely linked to one another.

The option strategist can artificially recreate any basic position’s risk-to-reward characteristics by using a specific combination of the other two instruments. Let's take a look at some of the basic synthetic positions to give you an idea of just what types of combination strategies are indeed possible.

The Synthetic Long Call
For instance, suppose an investor with a bullish long-term bias is worried about his or her stock’s short-term prospects but is reluctant to sell the stock immediately.

This investor can create a synthetic long call simply by buying a put, which is also known as a protective put strategy. The upside is still virtually unlimited, but the risk on the downside is capped until the option expires.

The Synthetic Long Put
Just as we can create synthetic long call positions, we can also create synthetic long put positions. The synthetic long put involves limiting the risk for any short stock position the investor might have.

For example, if you were short 100 shares of XYZ stock at $50 dollars, you would be long 1 XYZ 50 call. As long as you own the call, or until it expires, you have created a position with limited risk (if XYZ rallies) and substantial profit potential (if XYZ were to decline).

The profit potential is limited only by the fact that the stock price cannot fall below zero. Also, the call premium reduces the potential gains while the risk-to-reward graph for the combined position resembles the profit-and-loss diagram of a long put at expiration.

The Synthetic Long Stock Strategy
Another long equivalent position to appease the bullish investor is the synthetic long stock strategy. You construct this strategy by using both a call and a put. For instance, the trader can be long 1 contract of an XYZ 50 call coupled with being short 1 contract of an XYZ 50 put. This combined long call and short put position, both with the same strike price and expiration, has the same downside risk as owning shares of XYZ outright. The upside profit potential is also equivalent to the long stock position.

Other Synthetic Positions
The other basic combination strategies are the synthetic short call, synthetic short put and synthetic short stock positions. Keep in mind that these are just the fundamental building blocks for a variety of other combination strategies you can create. As you continue to become familiar with some of the more advanced strategies, continue to experiment and combine them to get the most favorable risk-to-reward profile possible. It’s an exercise that will surely serve the options strategist well in the future.