A Synthetic Call Strategy is a type of option strategy. Synthetic options are trading positions or portfolios that match the position of another asset. This strategy allows the trader to create unlimited profit with minimal loss. The strategy is named a Synthetic call because it does not include any call options. It is known by various other names such as Synthetic Long Call, Married put, or Protective put.
Traders holding the assets for the long term are bullish on that. On the other hand, traders fear the downside risks in the coming future. So, to gain profit and limit the risk, traders enter into the put options for the underlying assets he has been holding for a long time. If the price of that asset goes up, then the trader gets a profit on that put option, and if the price goes down, he bears the loss of the Put Option Premium paid only.
When to use the Synthetic Call Strategy?
This strategy can be utilized only when a trader is bullish on a long-term holding and is concerned about the downside risk. Instead of considering this strategy as profit-making, investors can call it the capital-preservation strategy. Sometimes it may reduce the chance of earning a profit because of uncertain market movement. Thus it works as an insurance policy on your investment. Few new traders may not be aware that everything comes at a cost, and even to protect your capital, you need to pay the premium, which is a cost, and maybe some other fees and commissions, so trade carefully.
What is the risk associated with the Synthetic call:
A trader can experience maximum loss if the underlying asset prices move higher than the strike price of the put option.
Simple terms - Maximum loss = Put Option Premium paid.
What does a trader gain out of this strategy?
A trader has the potential to gain unlimited profit when the price of the underlying asset goes higher than the purchase price adding the put option premium paid.
In simple terms - Profit = (Current price of the Underlying asset - Purchase) - the amount paid as premium.
What is the advantage of the Synthetic Call?
The synthetic call options' main advantage is providing protection against your long-term holdings.
What are the disadvantages of the Synthetic long call strategy?
If the underlying asset price goes down and the contract is executed, a trader may face a loss.
How can you exit from the contract?
There are two ways to exit the contract
1. By selling the underlying asset at some profit
2. By waiting till the options expire.
What are the types of synthetic options?
You can see there are two types of synthetic options; Synthetic long options and synthetic put options. In both types, a trader has a future position along with the options contract. The futures options serve as the primary asset while the options protect the position. It is called a synthetic call when you stay for a long time in the future position and purchase the put options.
Synthetic long call: Suppose a trader has bought some shares and is holding them. There is no profit or no loss on them. But there is a risk associated with the future price drop. To avoid such a situation, investors buy at-the-money and put options on the stock he is already holding. This activity will help protect the stock against the price downfall. We can relate this strategy to buying an insurance policy.
Synthetic long put: Trader combines two things here, one a short stock position with the long call options, in such a way that it looks like an exact copy of the long put option. An Investor having a short position will buy an at-the-money call option of the same stock he is holding to protect the stock against any price movement.
Why do traders use synthetic options strategies?
There are many reasons traders use option strategy, such as below:
An investor uses the synthetic strategy to alter the existing position in the market. With the help of a synthetic strategy, you can modify the position without exiting or closing the position. Let's say you are holding a position for a very long period, and now its price may fall, so just buy put options on those holdings you can protect against the price fall. This strategy plays an important role when you want to hold ownership in some company by holding its shares.
Another reason traders should use the synthetic approach is it reduces the number of transactions involved. As we know, every transaction costs something. Thus instead of selling stock and Buying Call Options makes the process quite lengthy and costly, it is advised to buy the put options.
A rare but good reason for employing synthetic strategy is to make some profit using arbitrage rules. Suppose the call option is more costly than the synthetic call options. You can sell them and buy them again. Doing so, you can earn the difference amount and make a good profit if the lost size is big. This strategy requires a lot of confidence and expertise and thus is not very famous among the newcomers if you are sure enough to handle arbitrage only then.
Example of how to create a Synthetic call:
Assume you have a long position shares of ABC limited, which are currently traded at Rs. 1249, in the lot size of 500. So you have purchased 500 shares of ABC at the price of rs. 1249 (1249*500) = 6,24,500
To protect your capital invested, you enter into the put options and buy 500 shares at the premium of Rs. 35 per share. Which totals to (500*35) = 17500.
Your total investment is now 6,42,000 in ABC limited shares.
General outcome: In the above scenario, if the price rises, you can get unlimited profit, and your maximum loss is limited to only Rs. 17500.
Scenario 1: What will be the outcome if the price drops to 1200?
If the share price drops to 1200, you will have a loss of -24500, and the put options would be traded at Rs. 80. That can give you a profit of 22500; (80-35)*500. So even if you execute the trade, you lose only the difference amount of 2000 (24500-22500).
Scenario 2, If the shares close at the current price of 1249, what will be the outcome?
If the market closes at 1249, your net loss will be Rs. 17500. Because your put options become zero and you will lose the premium paid.
Scenario 3, If the share price rises to 1300, what will be the outcome?
Assuming the breakeven point of your strategy was at 1284, and the strike price is 1300, you get to earn Rs. 16 per share (1300-1284), and you make a profit of Rs. 8000(500*16) on the capital you invested.
I hope you must be clear with the Synthetic Call Strategy by now. So if you hold any stock for a long try to use the Synthetic Long Call strategy by buying the put options. Your loss will be limited only up to Put Option Premium paid.