Synthetic Call Strategy

Investors often use different strategies to make money from the stock market. One of the popular and effective strategies is the Synthetic Call Strategy. It is a strategy that involves combining options contracts to create a position that mimics the behavior of owning a call option. This strategy can be used by investors to profit from the upward price movement of a stock or index. In this blog, we will discuss the Synthetic Call Strategy in detail and provide examples.

What is a Synthetic Call Strategy?

A Synthetic Call Strategy is an options trading strategy that is used to simulate the behavior of owning a call option. A call option is a financial contract that gives the holder the right, but not the obligation, to buy a particular stock at a specific price within a specific time frame. This strategy is created by purchasing a stock and simultaneously selling a put option with the same expiration date and strike price as the call option. The idea behind this strategy is that the put option provides a hedge against the downside risk of owning the stock, while the stock provides the potential for profit from the upside movement.

How does the Synthetic Call Strategy work?

Suppose an investor wants to invest in a stock that is currently trading at INR 100 per share. The investor believes that the stock will go up in the near future and wants to profit from it. To create a Synthetic Call Strategy, the investor will buy the stock for INR 100 and simultaneously sell a put option with a strike price of INR 100 and an expiration date of one month. The investor will receive a premium for selling the put option, which will provide some protection against the downside risk of owning the stock. If the stock price goes up, the investor will make a profit on the stock, and the put option will expire worthless. However, if the stock price goes down, the investor will be protected by the premium received from selling the put option.

Advantages of the Synthetic Call Strategy:

1. Limited downside risk: The Synthetic Call Strategy provides protection against the downside risk of owning the stock, as the put option acts as a hedge.
2. Potential for profit: The Synthetic Call Strategy allows investors to profit from the upside movement of the stock.
3. Lower capital requirement: Compared to buying a call option, the Synthetic Call Strategy requires a lower capital requirement.

Disadvantages of the Synthetic Call Strategy:

1. Limited profit potential: The Synthetic Call Strategy has limited profit potential, as the profit is limited to the difference between the stock price and the strike price of the put option.
2. Time decay: The Synthetic Call Strategy is subject to time decay, which means that the value of the put option will decrease over time.
3. Assignment risk: If the stock price falls below the strike price of the put option, the investor may be assigned the stock, which will result in a loss.

Example of the Synthetic Call Strategy:

Suppose an investor wants to invest in a stock that is currently trading at INR 200 per share. The investor believes that the stock will go up in the near future and wants to profit from it. To create a Synthetic Call Strategy, the investor will buy the stock for INR 200 and simultaneously sell a put option with a strike price of INR 200 and an expiration date of one month. The investor will receive a premium of INR 5 for selling the put option.

Scenario 1: If the stock price goes up to INR 250 per share, the investor will make a profit of INR 50 on the stock. The put option will expire worthless, and the investor will keep the premium received from selling the put option.

Scenario 2: If the stock price remains unchanged at INR 200 per share, the put option will expire worthless, and the investor will keep the premium received from selling the put option.

Scenario 3: If the stock price falls to INR 150 per share, the put option will be exercised, and the investor will be assigned the stock at INR 200 per share. However, the investor will still have received the premium of INR 5 for selling the put option, which will reduce the effective cost of acquiring the stock to INR 195 per share.

Conclusion:

The Synthetic Call Strategy is a useful strategy for investors who want to profit from the upward movement of stock while protecting themselves against downside risk. It involves buying a stock and simultaneously selling a put option with the same expiration date and strike price as the call option. The Synthetic Call Strategy provides limited downside risk, the potential for profit, and a lower capital requirement compared to buying a call option. However, it has limited profit potential, is subject to time decay, and has assignment risk. It is important to carefully evaluate the risk and rewards before using this strategy.

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