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As we stated in our opening explanatory piece on “synthetic” options trades, it’s possible to duplicate the risk/reward profile of nearly any trading position with a complex combination of options.
In today’s example, we’re going to look at how to create a synthetic long call position and show you a number of different benefits in adopting such a trade.
How’s it Made?
First off, a synthetic long call is comprised of two items: 100 shares of the underlying security and one long at-the-money put.
That’s it.
Now let’s look at exactly how such a strategy matches up with a straight long call.
It’s early October and Keurig Green Mountain (NASDAQ: GMCR) is trading at $75 per share (see chart below). Its coffee is great and the company looks sound, but you’re unsure of the short-term direction of the stock, so you decide to implement a synthetic long call position.
Why Not Just Buy a Call Option?
Your choice to go “synthetic” resides in the fact that ownership of the stock gives you both voting rights and a piece of the company’s dividend, both of which are important to you. Also, because you believe in the franchise over the long term, but are unsure of the near-term prospects for its shares, you feel safer owning the company than just buying an option – which, in the end, could theoretically expire worthless and leave you with a loss.
So you do it. You buy the shares and buy an at-the-money February call for $5.00. Your total cost for the trade is $8,000 ($7,500 + $500).
Indeed, your suspicions were right. The stock drifts lower for three months before spiking higher to give you a profit on expiration in February.
How much profit? Your stock rose from $75 to $120 – a $45 gain – good enough for a $4,000 net profit ($4,500 – $500 for the long put).
Good work!
The Same Profit/Loss Profile as a Call
A look at the numbers reveals that a long at-the-money $75 call would have given you the exact same profit performance, assuming that the cost of the call was also $500 – a fair assumption.
But what if the trade had gone sour?
We know what would have happened with a simple long call position. If the stock had slid toward, say, $60 and remained there until expiry, your initial $500 cost for the option would have been lost.
The same holds true with the synthetic long call. In fact, $500 would be your maximum loss under any circumstance, and that would occur if and when the stock dropped below $75, the purchase price of your stock.
How’s that?
Let’s say the stock was stuck at $75 at expiry. The put option would expire worthless and your loss would be $500 – the cost of the put.
And if the stock were to drop to $60?
Same result. The loss on the stock would be $1,500 ($7,500 – $6,000), but the gain on the long put would also be $1,500 ([$75 – $60] x 100). You would be net even except for the initial $500 outlay on the put.
With a capped downside but unlimited upside profit potential – and all the advantages of stock ownership to boot – the synthetic long call is an important tool for every option trader’s toolkit.
Forget everything you thought you knew about the market…
Because you’re about to discover a unique – and highly profitable – approach to stocks that maybe 1-in-1,000 investors know about. Yet it’s a simple, safe, and easy-to-use trading tactic that has, historically, made money nearly 90% of the time. Even better – following this simple strategy lets YOU determine how much money you make. Check it out now. Just click here. The next round of trades are all ready and waiting for you here.