What are Synthetic Calls?
When a trader goes long a stock and long the puts as well, the configuration is known as a synthetic call. The purpose of this strategy is to protect against a rapid decline in the stock price; for example, it is especially useful in a very volatile market such as the one we saw in 2000 to 2002. When choosing the strike price of the put option, it all depends on your risk parameters. Remember, you are using this strategy to protect you against unforeseen circumstances; therefore, it is generally a common practice to go one or two strike prices OTM, or out of the money. This would mean if you bought a $50 dollar stock, you would buy $45 or $47.50 puts.
Synthetic Calls Risk Characteristics
In taking a look at the risk characteristics of the synthetic call you will notice that the shape is the same as the long call option by itself. This is why this strategy is called the "synthetic" call.
Options strategy - Synthetic Calls
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So what is the difference between buying the synthetic call combination and just buying a long call option straight out? The key difference here is that the synthetic call will require a much larger cash outlay; you will need to purchase the stock and the put while the long call option is just the option price. However, the synthetic call is a less riskier proposition in percentage terms. Let's turn to an example:
Purchase Price of Stock $50.00
$47.50 Strike Put $2.25
$50.00 Strike Call $3.50
Using this example:
The synthetic call would cost $52.25 per share of this stock which means that if the stock dropped below $47.50 at expiration and the put was exercised, the owner of the synthetic call would have a maximum risk of ($50 + $2.25 -$47.50) or $5 per share. This is roughly 10% of the total position. On the flip side, in this same situation where the stock price dropped, the long call would expire worthless and the owner would lose 100% of their investment.
On the flip side, if the stock moved higher, the synthetic put option would have a lower breakeven price than the long call option:
Synthetic call breakeven = $50.00 +$2.25 = $52.25
Long call option breakeven = $50.00 + $3.50 = $53.50
Comparing Synthetic Calls against one another
Generally speaking, when you compare synthetic calls against each other in order to determine the most appropriate one, remember a few key points. The lower the strike price on the put option, the lower the option premium you will pay but the more risk you will take as well. Additionally, the further you go out of the money, the greater percentage risk of your overall investment you are taking.
This is where technical analysis really comes into play. When you can understand the support and resistance levels in a stock chart, you can start to make more informed decisions about which option to buy. Remember, investing in the stock market is nothing more than an odds game and learning how to read a chart makes you that much more powerful.
While buying deep out of the money put options is riskier than when buying higher strike premiums, the reward is also greater. Lower price options mean lower breakevens and larger profits if the stock runs in your favor.
Conclusion
The synthetic allows you to lower your downside risk when you are long a stock. When compared to buying the call outright, it is a matter of preference. While the synthetic call only loses a small portion of its total investment in a worst case scenario, it requires considerably more cash than the long call option strategy.
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