When it comes to investing and trading in the stock market, many people think it’s just about buying and selling shares. But there’s a lot more to it, especially when we start talking about options trading. One of the interesting strategies used in options trading is called the Synthetic Call Strategy.
In this article, we’re going to break down what a synthetic call strategy is, how it works, why traders use it, and what you need to be careful about. By the end, even if you’re just starting out, you’ll have a clear understanding of this smart and strategic way to trade.
Understanding the Basics: What Are Options?
Before we dive into the synthetic call, let’s quickly talk about options.
An option is a type of financial contract that gives you the right (but not the obligation) to buy or sell a stock at a specific price before a certain date. There are two types of options:
- Call Options: These give you the right to buy a stock.
- Put Options: These give you the right to sell a stock.
Options are commonly used to hedge risks or to make a profit in both rising and falling markets. Now, let’s see what happens when you start combining these in different ways – that’s where strategies like the synthetic call come in.
What Exactly is a Synthetic Call Strategy?
A synthetic call strategy is a combination of two positions:
- Long stock position (buying and holding a stock), and
- Long put option on the same stock (buying a put).
When you use both together, it creates something that behaves just like a call option. That’s why it’s called a synthetic call. You’re creating a situation that mimics the payoff of a real call option using other tools.
Formula:
Synthetic Call = Long Stock + Long Put
Example
Imagine you own 1 share of a company called ABCD Ltd., and it’s currently trading at ₹100.
Now, you also buy a put option for ABCD Ltd. with a strike price of ₹100, which expires in one month. This means you now have:
- A long stock position (you own the stock).
- A long put position (you have the right to sell the stock at ₹100).
No matter what happens in the market, you’re protected:
- If the stock price goes up, your stock gains value.
- If the stock price goes down, your put option kicks in and protects you by allowing you to sell the stock at ₹100.
So, you’ve created a situation that behaves just like owning a call option – where you benefit from a rise in the stock but limit your losses if it falls.
Why Use a Synthetic Call Strategy?
You might wonder: why not just buy a call option and skip the hassle? After all, it seems simpler. But many experienced traders prefer the synthetic call strategy because it offers several practical advantages that a standard call option doesn’t. Here are four detailed reasons:
1. Built-In Risk Protection (Hedging Existing Stock Holdings)
If you already own the stock, buying a put option alongside it acts as a built-in insurance policy. This protects you from significant price drops because the put option gives you the right to sell your shares at a fixed price, which limits your downside risk in volatile or uncertain markets.
2. Unlimited Upside with Controlled Downside
Just like a regular call option, a synthetic call benefits when the stock price goes up. But unlike a plain call, the synthetic version allows you to hold the stock and still manage risk through the protective put, giving you the best of both worlds – growth potential and downside coverage.
3. Flexibility in Strategy Design and Execution
Synthetic calls can be tailored to suit specific goals. For instance, you can choose different strike prices and expiry dates for the put option depending on your risk tolerance, market outlook, or tax planning needs – something not possible with a simple call option.
4. Possible Cost or Tax Advantages
In some market conditions or tax jurisdictions, building a synthetic call might be more cost-effective. For example, if call options are overpriced or taxed differently, combining stock and put positions could provide the same exposure at a lower cost or with better after-tax returns.
Pros of a Synthetic Call Strategy
Let’s look at the main advantages:
Limited Risk
Your losses are capped thanks to the put option.
Unlimited Upside
If the stock price goes up, your profit potential is unlimited (just like owning the stock).
Useful for Hedging
It’s a great tool to protect a stock you already own.
Lower Cost in Some Markets
Depending on how options are priced, building a synthetic position might be cheaper than buying an actual call.
Cons of a Synthetic Call Strategy
No strategy is perfect. Here are some things to watch out for:
Cost of the Put Option
Buying a put costs money. If the stock price doesn’t fall, you might lose that amount.
Requires Stock Ownership
You must own the stock already, or buy it, which means tying up a larger amount of money than with just an option.
Complexity for Beginners
Even though it’s not extremely hard, the concept may take time to understand for someone completely new to trading.
Payoff Diagram: What Does It Look Like?
A payoff diagram helps us visualise how much money you can gain or lose in different price scenarios.
Here’s what happens in the synthetic call:
- If the stock price goes up, your profit increases.
- If the stock price goes down, your losses stop at the strike price of the put.
It looks almost exactly like a regular call option’s payoff diagram.
When Should You Use a Synthetic Call Strategy?
Here are a few situations where this strategy makes sense:
- You already own the stock and want protection from a market drop.
- You expect the stock price to go up but want to reduce the risk of holding it.
- You want to replicate the payoff of a call option for strategic reasons.
For example, during uncertain market times, a synthetic call can give you peace of mind. You’ll still benefit from gains but won’t lose sleep over big drops.
Difference Between Synthetic Call and Actual Call Option
| Feature | Synthetic Call | Actual Call Option |
| Structure | Long stock + long put | Only call option |
| Cost | Higher (buying stock + put) | Lower (just option premium) |
| Capital requirement | High (you need to buy the stock) | Low |
| Risk | Limited (thanks to put) | Limited to premium paid |
| Profit potential | Unlimited | Unlimited |
Conclusion
The Synthetic Call Strategy is a powerful tool for investors and traders who want to take advantage of rising stock prices while also protecting themselves against losses. It offers the best of both worlds – profit potential and downside protection.
If you’re already holding a stock and want to hedge your position, or if you’re looking to replicate a call option for strategic reasons, this could be the right choice.
But remember, trading in the stock market – especially with options – carries risks. Always do your homework and consider practising with a demo account or seeking advice before diving in.
In the end, learning strategies like synthetic calls isn’t just about making money – it’s about making smart, informed decisions. And the more you understand, the more confident and successful you’ll be as an investor.
FAQs
What is the main purpose of a synthetic call strategy?
The synthetic call strategy is designed to replicate the payoff of a call option using a stock and a put option. It allows investors to benefit from price increases while limiting downside risk.
Is a synthetic call better than buying a regular call option?
It depends on the investor’s goals and capital. While a regular call option requires less money upfront, a synthetic call provides more flexibility and protection if you already own the stock.
Do I need to own the stock to use a synthetic call strategy?
Yes, the strategy involves buying and holding the stock as one of its components. Without owning the stock, you cannot create a true synthetic call.
Can I lose money with a synthetic call strategy?
Yes, you can lose money if the stock price falls, but your losses are limited to the cost of the put option and the drop in the stock’s value up to the strike price. The put acts as a safety net.
When should I consider using a synthetic call strategy?
This strategy is ideal when you expect the stock price to rise but want to protect against a drop. It’s especially useful during market uncertainty or volatility.
Are synthetic call strategies suitable for beginners?
They can be a bit complex for complete beginners, but with some basic knowledge of options, it becomes easier to understand. It’s best to practise with small amounts or use a demo account first.
