What Is a Synthetic Call Option Strategy?
A synthetic call is an options strategy that uses stock shares and put options to simulate the performance of a call option. A synthetic call involves buying an underlying asset (such as a stock) and then purchasing a put option on that asset. Investors who execute synthetic calls want to make sure they are protected from any major decreases in the asset's price. This strategy gives the investor a theoretically unlimited growth potential with a specific limit to the amount risked.
Key Takeaways
- A synthetic call is an option strategy to create unlimited potential for gain with limited risk of loss.
- This investing strategy buying and holding stock shares, then buying put options on the same stock.
- Synthetic call options are named as such because they do not involve any call options.
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How a Synthetic Call Option Strategy Works
A synthetic call begins with an investor buying and holding shares. The investor also purchases an at-the-money (ATM) put option on the same stock to protect against depreciation in the stock's price. Most investors think this strategy is similar to an insurance policy against the stock dropping precipitously during the holding period.
A synthetic call is also known as a married put or protective put. The synthetic call is a bullish strategy used when the investor is concerned about potential near-term uncertainties in the stock. By owning the stock with a protective put option, the investor receives the benefits of stock ownership, such as receiving dividends and holding the right to vote. While it is equally as bullish as owning the stock, just owning a call option does not bestow the same benefits of stock ownership.
Both synthetic and long calls have the same unlimited profit potential since there is no ceiling on the price appreciation of the underlying stock. However, profit is always lower than it would be by just owning the stock. An investor's profit decreases by the cost or premium of the put option purchased. Therefore, one reaches breakeven for the strategy when the underlying stock rises by the amount of the options premium paid. Anything above that amount is profit.
The benefit is from a floor, which is now under the asset. The floorlimits any downside risk to the difference between the price of the underlying stock at the time of the purchase of the synthetic call and the strike price. In other words, if the underlying stock trades precisely at the strike price when the option is purchased, the loss for the strategy is capped at the exact purchase price.
A synthetic call is also called a synthetic long call, married put, or protective put.
How to Use a Synthetic Call Option Strategy
A synthetic call is a capital-preserving strategy—not a profit-making strategy. The cost of the put portion of the approach becomes a built-in cost. The option's cost reduces the profitability of the approach, assuming the underlying stock moves higher, which is the desired direction. Investors should use a synthetic call as an insurance policy against near-term uncertainty in an otherwise bullish stock, or as protection against an unforeseen price breakdown.
Newer investors may benefit from knowing that their losses in the stock market are limited. Thissafety net can give them confidence as they learn more about different investing strategies. Any protection comes at a cost, which includes the price of the option, commissions, and possibly other fees.
Synthetic Call Option Strategy vs. Synthetic Put Option Strategy
Unlike a synthetic call option, a synthetic put option strategy combines ashortstock position with along call option. The goal of this strategy is to mimic along put option. With this strategy, the investor with the short position buys a call option that's at-the-money on the same stock. This protects the investor against any increases in the stock price.
A synthetic put isn't meant to make profits. Rather, it helps investors preserve their capital where the call portion's cost, which is referred to as the option premium, is built in. The price of the option reduces the profitability as long as the stock moves lower.
Investors use synthetic puts as a form of insurance, protecting themselves against short-term movements in stock prices. They may also use synthetic puts to hedge against unforeseen rises in the stock's price.
How Do Synthetic Calls Work?
A synthetic call is a trading strategy that attempts to create unlimited upside potential with a limited amount of loss. This is done by using stock shares and put options, where an investor tries to mimic the returns of a call option by buying a put option on a stock to act as insurance against a drop in the stock's price.
Are There Any Risks Associated With Synthetic Call Options?
The goal of a synthetic call option is to minimize losses while maximizing the potential for gains. Investors can use this strategy to make sure they are protected against major drops in the price of the underlying security. Although the strategy does provide some cushion, there are certain risks associated with synthetic call options. For instance, investors stand to lose if the price of the underlying asset decreases. There is also the high cost that comes with buying at-the-money options as well as the time investors lose/take to manage their positions.
Why Do Investors Use Synthetic Options?
Synthetic options—and synthetic trading of any kind—allow investors to benefit from trading financial assets without putting up too much capital. Synthetic trading strategies also provide investors with capital preservation, allowing them to maximize their gains while minimizing their losses. Having said that, investors may lose money in real-time if the market moves in the opposite direction. This can be mitigated with at-the-money options, which tend to be rather expensive compared to other options.
The Bottom Line
Investors can use different trading strategies to minimize their losses while they maximize their gains. A synthetic call option allows investors to hold a stock while buying a put option in that same stock. While it does provide an insurance policy against losses, investors should be aware that there are risks that come with synthetic call options—notably, expensive at-the-money options and the loss of capital if the stock's price drops, not to mention the time spent monitoring the strategy.
