Synthetic Long Call

[Igor 10]

A synthetic long call is a synthetic trade meaning that it is a trade involving an underlying security compounded by derivatives (in this case options). The investor in this case has decided that the stock price will go up (hence the term "call") and buys the stock while simultaneously buying near-the-money puts. This type of position insures the stockholder a maximum loss of the put's strike price and at the same time unlimited potential profits.

 

 

For example (see diagram) if the shareholder has 100 shares of stock XYZ with a share price of $52, then a contract (1 contract=100 shares) can be purchased to limit losses at the strike price of the option. Suppose the option strike price is $50, then the maximum loss per share is $2 plus the premium paid (the cost of purchasing a contract). Suppose the premium for a contract is $2 (1 contract =100 shares=$200), then the maximum loss in the trade is $400.

 

On the other hand, the profit potential is unlimited if the share price goes up and the only loss is that of the premium paid of $200. If the stock reaches $54, then the shareholder has broken even in the trade and realizes only profit as the stock goes up.

 

When are synthetic long calls a valid strategy?

Synthetic long calls are a bullish position and are valid strategy for playing riskier, higher volatility stocks while at the same time reducing the amount of inherent risk in incurring a steep loss. Investors who desire to play such a stock for the chance of extreme profits (such as in a much-hyped tech stock) often use this strategy. In this case, the puts purchased provide a level of insurance in case the trade goes wrong and the stock gets crushed.

 

Investors who use this strategy have to pay close attention to the amount of implied volatility (IV) in premium prices since the maximum loss incurred can be much more substantial with higher premium prices.

 

The synthetic long call is also a valid strategy when more versatility is needed by the investor in assessing the stock's performance. For example, the investor can sell the put at any time, sell the stock at any time, or execute delivery at the strike price. This allows a change in overall strategy for the trade all the way until the option's expiration.

 

Types of stocks in which to consider long call strategy

Stocks that respond well to this strategy are oftentimes small to mid-cap sized stocks with moderate to high amounts of volatility. Stocks with higher price swings that have just been through a steep selloff or where good news is expected are good candidates for a long call.

 

Volatile ETFs and index funds as well are candidates for this strategy. One of the keys to putting on the lowest risk trade with any of these stocks is to pay attention to implied volatility in premium prices and go for the lowest possible put option price in order to avoid sharp drops in implied volatility. This would minimize any loss should the stock trade sideways.