If you invest regularly in the stock market, you might be curious about what a synthetic long call is. Don’t be intimidated by this term! It sounds complicated, but when you take a closer look at it, it’s not.
We’ve put together some information for you about what a synthetic long call is and when to use it. Read on to learn how to use it.
Table of Contents
- What Is A Synthetic Long Call?
- How A Synthetic Long Call Works
- When Not To Trade A Synthetic Long Call
- What Is The Risk In Trading A Synthetic Long Call?
- How Does Time Decay Effect A Synthetic Long Call?
- What Is The Breakeven Point Of A Synthetic Long Call?
What Is A Synthetic Long Call?
A synthetic long call mimics the performance of a long call option, albeit by combining different securities.
A synthetic long call is created when a long put is purchased for every 100 shares of stock you own. This replicates the payoff you would get if you purchased call options alone.
On the plus side when you use a synthetic long call, you still get the benefits of being a stockholder, such as the right to vote in stockholder meetings and the right to receive dividends (which you would not enjoy if you purchase call options).
The downside is the transaction costs may be higher because a synthetic call requires two transactions, the purchase of long puts and shares, versus just one transaction cost when buying long calls directly.
Investors use synthetic long calls when they want to hold onto a stock for a long period of time that they fear may go down in the short-term. Using a synthetic long call helps lower the risk of stock losses in such situations.
How A Synthetic Long Call Works
A synthetic long call protects investors against losses if a stock should go down instead of up.
For example, suppose you own stock in a corporation, called Hot But Volatile [ticker symbol: HBV].
If you simply own shares of HBV (but have no options positions on it), you make money when the share price rises. However, if the share price goes down you lose money.
To limit your risk of losses, you may consider a synthetic long call which can be constructed by buying put options for HBV.
When HBV share price falls, the put options rise in value, thus covering a good chunk of the losses from the stock going in the wrong direction.
Synthetic Long Call Max Profit Potential
The synthetic long call has nearly unlimited profit potential just as a traditional long call does.
There is no theoretical ceiling on the stock’s appreciation, however, you will make less money if the stock goes up than you would had you purchased the stock alone.
That’s because when you purchase a put option, your profit is reduced by the cost of the put option, so your stock’s value must rise above the price of the put option before you can begin to turn a profit.
Commonly, investors purchase at-the-money put options as part of this strategy.
Why Trade Synthetic Long Calls
The major benefit of the synthetic long call is that the put options cap any losses should the stock go down in price instead of up.
If the stock goes down, losses are limited only to the total cost of the shares plus the put options minus the put strike price.
How To Get Started Trading Synthetic Calls
The first step to creating a synthetic long call is to purchase shares of stock in a company using a reputable broker.
At the same time as you purchase these shares, place an order to buy an at-the-money (ATM) put option on the same stock.
This means that you purchase a put option at the stock’s current value. For example, if the stock is worth $75, buy a put option at strike $75 also.
The rule of thumb is for every 100 shares of stock you own, buy 1 long call put contract.
When Not To Trade A Synthetic Long Call
A synthetic long call is not appropriate to use in all situations.
Despite the potential for profit, synthetic long calls are not so much to make profits as they are designed to preserve capital.
In other words, the synthetic long call is like an insurance policy against a stock dropping in price more so than it is a vehicle to earn profits on a stock.
Nevertheless if the stock rises, you may actually make more money from the share price increases than you lose from the put option losses.
In general, you want to use a synthetic long call if you are worried about short-term losses in a stock you plan to hold onto for a while.
Or if you are new to investing, you might want to use synthetic long calls to help limit your losses while you are learning how to invest effectively.
What Is The Risk In Trading A Synthetic Long Call?
Risks are limited when using a synthetic long call, but they are not non-existent.
If the stock goes up in value instead of down, the cost of put options could cut into your profits. However, using a synthetic long call help to mitigate the risk of loss because your losses will be limited if the stock goes down in price.
Another risk is that the share price never returns back from its dip lower. The idea behind the synthetic long call is to protect your shares when they are falling, and sell the put for a profit when the share price has bottomed out.
If you were to sell your put options and subsequently the share price continues to falling you could experience higher losses than had you simply placed a limit order to sell your stock when the share price first started to fall.
Or if you hold on to both your shares and the put options, but the share price never recovers your loss will equal the maximum risk in the trade, which is the total cost of the shares plus the cost of the put(s) minus the strike price of the put(s).
How Does Time Decay Effect A Synthetic Long Call?
The put option you purchase is a long option and all long options suffer from a factor called time-decay. So over time, the premium in the put option will depreciate.
All else being equal, the put option will steadily lose value until all its time-value is gone.
If the share price remains above the put option strike price at expiration, the put option will expire worthless and you will lose 100% of the price you paid for the put.
On the other hand if the share price is below the put strike price when expiration comes around, the put will be automatically exercised and your shares will be sold at the put strike price, resulting in a loss equal to the maximum risk in the trade.
What Is The Breakeven Point Of A Synthetic Long Call?
The breakeven point is the point at which you are neither making nor losing money from your synthetic long call.
This doesn’t mean it’s time to sell!
The stock will change in value; if it goes down, you’ll make money off the put option and if it goes up you’ll make money off the stock itself. So don’t give up when you hit the breakeven point.
For example, if the share price is $100 and you paid $5 for the put option, the theoretical breakeven at expiration of the option is $105.
Another way of thinking about this is that the share price would have to rise to $105 in order for you to not lose money by expiration.