Synthetic Long Call

In this strategy, we buy a stock we feel bullish about. Now, it is a possibility that we may be wrong and the stock price may go down. So, to safeguard our investment, we buy a put option on the stock. This enables us with the right to sell the security at a certain price (i.e. the strike price). The strike price can be at the money or slightly below out of the money.

In case the stock price rises you will get the full benefit of the price rise. And if the stock price falls, you can exercise the Put Option. You have limited your loss in this manner. The Put option stops your further losses. The strategy can yield either limited loss or unlimited profit. The payoff diagram of this strategy looks like the diagram of a long call strategy and therefore it is referred to as Synthetic Call!

  • When to Use:When ownership is desired of stock yet investor is concerned about near-term downside risk. The outlook is conservatively bullish.
  • Risk: Losses limited to Stock price + Put Premium – Put Strike price
  • Reward: Profit potential is unlimited.
  • Breakeven: Put Strike Price + Put Premium + Stock Price – Put Strike Price
  • Profit when: Price of Underlying > Purchase Price of Underlying + Premium Paid.
  • Loss when: Price of Underlying <= Strike Price of Long Put.

Let’s understand with an example:

Synthetic Long Call

The above image is a diagrammatic representation of the Synthetic long call. Again, on ‘X’ axis, we have the stock price and on the ‘Y’ axis, we have the payoff.

Here, I shorted 1 lot of NIFTY.
Buy Stock Current Market Price of the stock (Rs.) 12100
Strike Price (Rs.)12000
Buy PutPremium (Rs.)150
Break Even Point (Rs.) (Put Strike Price + Put Premium + Stock Price – Put Strike Price)12250

Analysis: It is a strategy with limited risk. If the market falls, your losses are limited and if it rises, your profit can be unlimited.

Conclusion

  • A Synthetic Long Call offers limited risk and unlimited profit.
  • In this strategy you buy stocks and also a put option on those stocks.
  • The strategy is labeled as Synthetic Long Call as the payoff chart for this strategy looks like a long call payoff chart.
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