Any type of risk on the portfolio can be reduced or mitigated with the help of synthetic options. Synthetic Calls And Puts options are created by merging two financial instruments and making modifications.
When you merge a long position with another long position in At-the-money Call Option, you get a Synthetic call. You get the Synthetic put option when you merge a short position with another short position. We shall continue with understanding Synthetic put strategy in this article.
Definition of Synthetic Put Strategy:
A synthetic put strategy is created by combining a short stock position with the long call option. An Investor holding a short position stock buys at the money call options on the same stock he is holding. This is done to protect the capital against a downward trend. If the price moves upside, there is an unlimited profit, and a synthetic put strategy is implemented to limit the risk in case of a price fall. The Synthetic put strategy is known by some other names, too; Married call and Protective call.
The synthetic put strategy is used when the market is bearish. It works as an insurance policy. But the only difference here is that the investor wishes that the underlying asset's price should decrease and fall instead of rising.
Investors will buy the put option on the stock he already has by paying some premium. The reason for paying the premium is to limit the losses of the underlying stock if it falls.
What is the Maximum loss an investor can face?
The strategy is designed to limit the loss; thus, a loss is very limited in this strategy. The worst scenario can be that the stock price rises above the strike price. In such a case, you have to close the position. Execute the call option and close the position. Your maximum loss will be as below:
Loss = the stock price (that is high) - the strike price (at which you entered into the contract) - Premium paid.
What Maximum profit can a trader earn:
The profit is unlimited if the price moves as per the anticipation. The worst thing that can happen is the options expire worthlessly, and you lose the premium paid.
Profit = positive change in the price - premium paid.
Advantages of Synthetic Calls And Puts Strategy:
Potential to get unlimited profit
Limited chance of loss.
If the trader has a long position, then by entering into a synthetic strategy and buying the put options, he can safeguard against the uncertainties.
As the trader still holds the stock, he is liable to get all the benefits like dividends and ownership in the company.
The disadvantage of the Synthetic Put Options Strategy:
It is very expensive to enter as the trader must buy the underlying asset and put options.
This can be proved fruitful only when the price rises more than the premium you paid.
This may not be the most profitable because you have to pay some part of your profit in the form of a premium.
Key factors to be noted while implementing Synthetic Put Options Strategy:
A trader must consider the factors below while applying Synthetic Calls And Puts strategies.
Please make sure that the underlying asset's price is bullish.
As you have to buy the put option, ensure you have enough time for contract expiration.
The time decay factor will affect the life of the options, and the option contract may lose its value.
In the Synthetic put strategy, put option contracts are only for protecting your capital invested, so you pay a higher premium to get more protection and a lower premium to get low protection.
When you are entering into this strategy, remember to buy an ATM put. A trader can choose anything based on his portfolio and risk management strategies.
Make sure that the options have the liquidity to create another position.
Why use the Synthetic put options strategy?
There can be many reasons for a trader to use the synthetic put strategy; some are as below:
The first and most common reason to use a synthetic strategy is to modify any existing position without closing it. By buying put options or call options on your existing stock, you can modify it and make money.
The second reason is you do not have to lose your current holding and can enjoy the benefits like bonuses, ownership, etc.
Synthetic strategies reduce the number of transactions involved in changing the position. Along with the less transaction, the transaction fees attached to each transaction also reduces.
Example of Synthetic long position strategy:
Let us assume ABC stock is currently traded at Rs 50. The options contract for ABC stock can be purchased by paying a premium of Rs. 2.
Assuming lot size of 100 shares.
If a trader sells 100 shares (1 lot) he gets 100*50 = Rs 5000
If a traders buy the 100 shares (1 lot by paying a premium), he pays 100*2= 200
Let us see the possible outcomes:
Case 1: If the stock price of the underlying asset does not change and stays at Rs. 50?
A trader can sell 100 shares (1 lot), but there will be no profit
Loss of brokerage fees or taxes paid if any
The trader gets Rs 4800
The total loss will be Rs. 200, which you paid in the form of a premium.
Case 2: If the price of the underlying asset increases from Rs. 50 to Rs. 70, what will happen then?
A trader can sell the shares and get a profit of Rs 20 n each share, that is 100*20 = Rs 2000
Call option expires in-the-money that is (70-50) *100 = Rs. 2000
Total loss a trader faces = Rs. 2000+Rs. 2000-Rs.200 (premium paid)
Case 3: if the price of the underlying asset falls from Rs. 50 to Rs. 30, what will happen then?
A trader can Sell the lot of 100 shares (50-30) 20*100 = Rs. 2000
Call options got expired worthlessly
Total profit gained by the trader = Rs. 2000- Rs.200 premium paid = Rs 1800.
We hope you are now clear about the synthetic put strategy, how to use Synthetic Calls And Puts, and when to use it. It can be useful for protecting your investment and limiting the risk on your portfolio. If you have any questions, let us know in the comment section below.