Knowledge Base

What is a Synthetic Long Call Strategy?

in Trading Strategies
Tags: synthetic long calltrading strategy

Buy Stock, Buy Put: What is a Synthetic Long Call Strategy

Derivative contracts (such as futures and Options) are fascinating. They allow investors to take a variety of positions (even self-contradictory ones) in various assets and make large profits at small costs. One maneuver that investors use to limit their losses while keeping their profit potential unabated is called a Synthetic Long Call.

What is a Synthetic Long Call

Synthetic Long Call refers to an arrangement where an investor buys an asset, such as a stock, currency, commodity or index, together with a Put Option on the same. A Put Option is a contract that allows him to sell the asset at a specific price (called strike price) on a future date, at his own discretion. The arrangement is named a Synthetic Long Call because it confers on the investor the same benefits as going long on (purchasing) a traditional Call Option—a contract that allows him to buy an asset at a pre-defined price on a future date.

Benefits of a Synthetic Long Call

Synthetic Long Calls are akin to insurance. They are purchased by investors who are bullish on an asset (i.e. expect it to appreciate) but want to make provisions to limit their losses in case the investment backfires. So, they buy the asset and wait for it to appreciate, while simultaneously buying a Put Option with a strike price similar to the purchase price of the asset. This allows the investor to sell the asset at the price he bought it for, in case it depreciates. In case the asset is priced above the strike price on the expiry date, he can let the Option expire while continuing to hold his stock.

How a Synthetic Long Call works

Let us assume an investor buys 100 shares of a company, that he feels will appreciate, at a price of Rs 40/share (total investment of Rs 4000). To protect himself from an unexpected fall, he also buys a Put Option on the same shares at the same strike price. This costs him a premium of Rs 50. Now, he can sell his investment at Rs 40/share (the purchase price) even if they depreciate. If they appreciate to say Rs 45/share, as expected, he would let the Option expire and sell it in the market at this new price and make a gain. However, if they fall to say Rs 30/share, he would exercise his Option and sell them at Rs 40/share, recovering his entire investment, for the small cost of Rs 50. The entire strategy saves him from a loss of Rs 1500 (Rs 15 per share), which he would have incurred without the Option.

Synthetic Call vs Traditional Call Option

An investor can also use a conventional Call Option to profit from the appreciation of a stock. He would buy a Call Option with a strike price equal to or below the current price of the shares. This would enable him to buy the shares at this price in future. He would then sell it in the market at the new, higher price. If the price does not appreciate, he will let the Option expire, losing only the premium. However, if he feels that the stock will appreciate even further, he would have to extend (also called rollover) his contract by buying a new contract and paying premium afresh. He would continue doing this until he feels that the stock has peaked.

Secondly, Options are cash settled. They don’t grant the investor ownership of the stock. A synthetic Option, in contrast, provides the investor physical possession of the stock. If he feels that the stock has further appreciation potential, he can let the Put Option expire while continuing to hold the stock. There is no need for repeated premium payments on account of rollovers.