Chances are you have had (or have right now!) unwanted positions hiding in your trading account.
And I’m not talking about a fat finger trade that you accidently left on overnight.
I’m talking about synthetic positions.
What is a synthetic position?
A synthetic position occurs when you take a long and short position in the same currency against different counter currencies at the same time.
For example: if you buy GBP/USD, and then sell GBP/NZD, the GBP components of the trade cancel each other out, leaving you with a long NZDUSD trade.
This means that your profit and loss will be dictated by the movements in NZDUSD.
Another example would be if you buy EUR/JPY and sell AUD/JPY. In this case, you would have a synthetic long EUR/AUD position, with the JPY components of the trade cancelling each other out.
Of course, this would depend on whether the trades were of equal value. If for example you bought 50,000 EUR/JPY and sold 25,000 AUD/JPY ,then you would have a synthetic long position worth 25,000 in EUR/AUD and maintain a 25,000 position long EUR/JPY.
The bad and the ugly
Synthetic positions are not necessarily a bad thing. In fact, they can be a very useful tool for the trader.
But let’s start by looking at the dangers a hidden synthetic positon presents.
The first and perhaps most important of these is that synthetic positions can create a position-sizing error.
Imagine you have a long AUD/USD trade in your account. Then you take a short EUR/AUD and a long EUR/USD trade, creating a synthetic long AUD/USD position. All of a sudden you have effectively two long AUD.USD positions. This doubles your risk to a reversal in AUD/USD. Certainly not a good thing.
The second problem with having synthetic positions is you can end up with a trade in your account that you don’t actually like.
Say you take a long CAD/JPY and a long USD/CAD, creating a synthetic long USD/JPY position. But if you look at USD/JPY, perhaps it is stuck in a range, or has reversed off support. Perhaps it is a risk-on environment and a short USD/JPY trade is not appropriate.
You need to check if the synthetic position is actually a trade you want to be in.
And this brings us to how to use synthetic positions to your advantage.
There might be times when you want to roll your position into another pair.
Let’s say you have a view that you want to be short CAD, and are currently short against the EUR. But now EUR/USD is reversing off resistance, which is going to pressure the trade. At the same time, USD/CAD looks like it could have 100 pips left to go before topping out
So instead of closing out of the EUR/CAD position, you take a short EUR/USD position, creating a synthetic USD/CAD long. This is a better position to have at the time. You then look to exit out of the trade based on the price action in USD/CAD.
Clear as mud?
If this is confusing, no worries, you will get used to it in time.
As a simple rule, keep in mind that if you go long and short the same currency (i.e. long EUR and short EUR) at the same time, it will create a synthetic position. This can expose you to more risks.
The important thing is that you should persist through the learning curve, because it’s these risk management skills that will give you longevity as a trader.
About the Author
Sam Eder is a currency trader and author of the Definitive Guide to Developing a Winning Forex Trading System and the Advanced Forex Course for Smart Traders (get free access). He is the owner of www.fxrenew.com a provider of Forex signals from ex-bank and hedge fund traders (get a free trial). If you like Sam’s writing you can subscribe to his newsletter.