Execute A Synthetic Long Call – Bullish Strategy

Introduction To Synthetic Long Call

Execute A Synthetic long call

A synthetic long call consists of buying the underlying security while simultaneously buying a put to protect the underlying security against price decreases. In this way, the synthetic position’s risk and reward profile imitates that of a long call, that is, the synthetic position has an unlimited profit potential with a limited loss potential.

Difference between a synthetic long call and a long call

A synthetic long call involves buying the underlying security and an adequate quantity of put option contracts to insure against price declines. The long call however, is just the buying of call options.

Synthetic long call trade requires cash outlay

A synthetic long call trade  requires a cash outlay as the trader is has to buy the underlying security and the put option in order to imitate the risk and reward profile of a long call.

Steps

Step 1 : Perform economic, fundamental and technical analysis
Step 2 : Outlook – Bullish
Step 3 : Study the option chain
Step 4 : Breakeven Analysis & Breakeven point
Step 5: Understand Your Profit Zones
Step 6 : Limited loss potential
Step 7 : Loss calculation
Step 8 : A synthetic long call has unlimited profit potential
Step 9 : Calculate Profit
Step 10 : Calculate Risk & Reward Ratio
Step 11 : Set Up Trade : Executing a synthetic long call
Step 12 : Exit Trade
Step 13 : Record Trade In Diary
Step 14 : Example

 

Step 1 : Perform economic, fundamental and technical analysis

Before executing a synthetic long call, the options trader should conduct economic analysis, fundamental analysis and technical analysis. Look out for events, announcements that will cause the price of the underlying security to move up significantly. By performing fundamental analysis, the trader can determine if the price of the underlying security is worth a lot more than what it is currently. Last but not least, analyse the charts for a suitable entry point. Some chart patterns the options trader should look out for are:

 

Read : Basic Economic Analysis, Basic fundamental Analysis and Introduction to technical analysis

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Step 2 : Outlook – Bullish

A trader who executes a  synthetic long call is bullish on the price of the underlying security. When the price of the underlying security goes up, the trader’s realisable profit goes up in tandem.

A synthetic long call has a similar risk/reward profile to a long call.

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Step 3 :Study the option chain

Examine the option chain and determine the options to use in the construction of the synthetic long call.  Also, be mindful of the entry price of the underlying security.

Read :  Learn to read and understand options chain

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Step 4 : Breakeven Analysis & Breakeven point

The breakeven point is a price point on the horizontal axis that yields a $0 profit or a $0 loss. That means that at this price point, there is neither profit nor loss. The breakeven point can be calculated using the formula below:

Total premiums paid + Acquisition price of the underlying security

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Step 5: Understand Your Profit Zones

Execute A Synthetic long call

When the price of the underlying security is above the upside breakeven point, the trade is in a profitable zone.

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Step 6 : Limited loss potential

Since the risk/reward profile is similar to that of a long call, a synthetic long call has a limited loss potential. A loss is realisable when the exercise(strike) price of the put is greater than or equal to the  price of the underlying security.

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Step 7 : Loss calculation

The loss can be calculated by using the formula below:

Total commissions paid to broker + total premium paid for put(s)

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Step 8 : A synthetic long call has unlimited profit potential

The synthetic call has has an unlimited profit potential. This means that there is no ceiling to to potential realisable profit. As the price of the underlying security rises, the realisable profit also rises in tandem.

As long as the price of the underlying security is above the breakeven price point, there will be a realisable profit of the synthetic position is exited.

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Step 9 : Calculate Profit

The profit can be calculated as:

Price of the underlying security – premium paid for puts – acquisition price of the underlying security

For example, if a put cost $2 and the acquisition price of the underlying security is $10 while the current trading price of the underlying security is $20, the profit is:

$20 – $2 – $10 = $8

The profit per share is thus $8.

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Step 10 : Calculate Risk & Reward Ratio

Estimate the  potential profit based on a certain price target and calculate the risk and reward ratio to find out if the trade is attractive on that basis.

Read more : Understanding Risk/Reward Ratio For Option Traders

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Step 11 : Set Up Trade : Executing a synthetic long call

A trader who executes a synthetic long call will do so by:

  • Buying 100 shares in the underlying security
  • Buying a put option

Because every option contract represent 100 shares in the underlying security, only 1 put option contract is to be bought alongside with the buying of 100 shares in the underlying security. Hence, the above ratio is to be adhered to. If a trader buys a 1000 shares in the underlying security and also buys 10 put options, it is also considered a synthetic long call as the risk and reward profile of the synthetic position still imitates that of the long call.

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Step 12 : Exit Trade

When the profit is reasonable, the trade can be exited. If not, the maximum loss, if the call is structured carefully, is equal to the premiums paid for the put options.

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Step 13 : Record Trade In Diary

Record the trade in a diary and determine if the trade was successful. Find ways to improve on the trade process, to make  the trade more profitable.

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Step 14 : Example

The price of TTT Corp is trading at $40. An options trader buys a December 40 put at a premium of $2, paying $200 for the contract. He also buys 100 shares of TTT corp at $40, forking out $4000 for the shares. When the price of TTT rises to $60 by the expiration date of the put options, the trader makes a profit of :

$6000 – $4000 – $200 = $1800

However, if the price of TTT Corp falls to $20, the trader’s maximum loss is only $200 as the downside was protected by the put options. In this case, there would have been a loss of $2000 on the underlying security but a profit of $2000 on the put option. Hence, the trader’s loss becomes $200, the premium paid for the put option contract.

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Long call Vs Synthetic Long Call

Even if the put options in the synthetic expire worthless, a trader can still hold on to the  underlying security to profit from any price movements to the upside. However, for a long call, the call becomes worthless due to time decay. Hence, in a synthetic long call, there is a longer time horizon for the trade to perform.

Read also : Execute A Long call options trading strategy : Profit from price movements to the upside

Comparisons of long call vs long stock

Synthetic Long Stock : Bullish strategy

Synthetic Long stock with options of different strike prices(split strikes)

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