What is a Synthetic Call?
A synthetic call is an options strategy that uses stock shares and put option to simulate the performance of a call option. This gives the investor a theoretically unlimited growth potential with a specific limit to the amount risked.
- A synthetic call is an option strategy to create unlimited potential for gain with limited risk of loss.
- This investing strategy uses stock shares and put options.
- This strategy is so called because it does not involve using any call options.
- The strategy is also known as synthetic long call, married put or protective put.
How a Synthetic Call Works
A synthetic call, also referred to as a synthetic long call, begins with an investor buying an holding shares. The investor also purchases an at-the-money put option on the same stock to protect against depreciation in the stock's price. Most investors think this strategy can be considered similar to an insurance policy against the stock dropping precipitously during the duration that they hold the shares.
A synthetic call is also known as a married put or protective put. The synthetic call is a bullish strategy used when the investor is concerned about potential near-term uncertainties in the stock. By owning the stock with a protective put option, the investor still receives the benefits of stock ownership, such as receiving dividends and holding the right to vote. In contrast, just owning a call option, while equally as bullish as owning the stock, does not bestow the same benefits of stock ownership.
Both a synthetic call and a long call have the same unlimited profit potential since there is no ceiling on the price appreciation of the underlying stock. However, profit is always lower than it would be by just owning the stock. An investor's profit decreases by the cost or premium of the put option purchased. Therefore, one reaches breakeven for the strategy when the underlying stock rises by the amount of the options premium paid. Anything above that amount is profit.
The benefit is from a floor which is now under the stock. The floor limits any downside risk to the difference between the price of the underlying stock at the time of the purchase of the synthetic call and the strike price. Put another way, at the time of the purchase of the option, if the underlying stock traded precisely at the strike price, the loss for the strategy is capped at exactly the price paid for the option.
When to Use a Synthetic Call
Rather than a profit-making strategy, a synthetic call is a capital-preserving strategy. Indeed, the cost of the put portion of the approach becomes a built-in cost. The option's cost reduces the profitability of the approach, assuming the underlying stock moves higher, the desired direction. Therefore, investors should use a synthetic call as an insurance policy against near-term uncertainty in an otherwise bullish stock, or as protection against an unforeseen price breakdown.
Newer investors may benefit from knowing that their losses in the stock market are limited. This safety net can give them confidence as they learn more about different investing strategies. Of course, any protection comes at a cost, which includes the price of the option, commissions, and possibly other fees.