Synthetic Long Call Options
Strategy to mimic owning a stock
Learn how to use covered calls to reduce the price of buying a call or to hedge for the downside potential of your existing stocks.
Bullish Option | Option Strategies
Synthetic Long Calls
Learn how to mimic owning a stock with leverage
A synthetic long call strategy can be used when you expect a fast and dramatic rise in the price of an underlying stock. Instead of buying a stock outright, the synthetic long call strategy allows you to use the leverage of options and less up front costs. This leverage will, however, come at the price of a relatively large margin requirement to cover the risk of having a short put option.
By owning a call option and selling a put option at the same strike price, the position’s delta exposure will be +100. Compared to buying shares of stock, a trader may be able to enter a synthetic long stock position with a lower margin requirement than buying shares.
The synthetic long call is set up with an ATM long call option along with an ATM short put option. The strategy can be set up for either a credit or a debit depending on where you situate the short put strike price.
- Buy ATM Call
- Sell ATM Put
Buying the call gives you the right to buy the stock at strike price A. Selling the put obligates you to buy the stock at strike price A if the option is assigned.
If you remain in this position until expiration, you will probably wind up buying the stock at strike A one way or the other. If the stock is above strike A at expiration, it would make sense to exercise the call and buy the stock. If the stock is below strike A at expiration, you’ll most likely be assigned on the put and be required to buy the stock.
The synthetic long call is set up with an ATM long call option along with an ATM short put option. The strategy can be set up for either a credit or a debit depending on where you situate the short put strike price.
- Buy ATM Call
- Sell ATM Put
Buying the call gives you the right to buy the stock at strike price A. Selling the put obligates you to buy the stock at strike price A if the option is assigned.
- Leverage
- Less up front cash layout
A synthetic long call option allows you to mimic owning a stock but with leverage and less or no up front cash layout.
This combination is ideal when considering a stock that you feel has the potential to run up fast and dramatically.
You would only use a synthetic long call strategy if you feel that a stock will make a fast and dramatic run upwards.
You must have the direction of the trade correct. If the stock moves against you, you can see significant losses due to the short put option.
Close a synthetic long call strategy before expiration. If you remain in this position until expiration, you will probably wind up buying the stock at strike X one way or the other.
- If the stock is above strike X at expiration, you will want to exercise the call and buy the stock. You will be able to buy the stock at the strike price ( which is lower than the actual price )
- If the stock is below strike X at expiration, the stock will be out of the money on the put option. Remember that when you buy a call, you want the stock price to go up. If the stock is below the strike price of the put, you will most likely be assigned on the put and be required to buy the stock.
Dividends will increase put prices while decreasing call prices because stock prices will be expected to drop by the amount of the dividend after the ex-dividend date.
Dividends within the expiration period will increase the chances of establishing the strategy for a net credit as opposed to a net debit.
Credit Spreads
- Buy ATM call X
- Sell ATM put X
- Stock should be at or very near strike X
Synthetic Long Call Option Strategy
Strategy Discussion
Speculators and investors use this strategy differently.
- Speculators typically seek short-term profits and do not want to buy the underlying stock. Speculators, therefore, use this strategy when the forecast is “very bullish.”
- The short put has a lower margin requirement than purchasing stock, so less capital is required.
- Also, the put premium is used to reduce the cost of the call, which has two advantages.
- First, it lowers risk if the stock trades sideways and, second, it lowers the breakeven point if the stock rises
The disadvantage is that the short put has substantial risk.Impact of stock price change
Synthetic Long Call Option Strategy
What is the risk associated with creating a synthetic long stock?
A common mistake made by speculators is to think that a bullish split-strike synthetic position is a “zero-cost call option” (because the premium received for selling the put is used to pay for the call). Such thinking overlooks the risk of the short put, which is substantial if the stock price declines. Just like all other investment and trading strategies, a bullish split-strike synthetic position requires planning for both good and bad outcomes. If the stock price rises, when will the position be closed and the profit realized? If the stock price falls, when will the position be closed and the loss taken? These are subjective questions that every investor must answer personally.
Credit Spreads
- Buy ATM call X
- Sell ATM put X
- Stock should be at or very near strike X
Synthetic Long Call Option Strategy
How Do You Set Up a Synthetic Long Call Option?
- The synthetic long call option strategy tries to mimic the action of buying a long stock. As such, it is very important to have the direction of the trade correct. Because the long option is partially financed by the short option, the strategy will have substantial risk because of the naked short option. ( risk is the strike price +/- [ the credit OR debit ]
Option Basics
How Does a Synthetic Long Call Option Change with Volatility and Time
A call option will benefit from :
- a dramatic rise in the stock is the best case scenario
- Time value is relatively neutral because you have both a long and a short option that cancel each other out
- Volatility changes are also relatively neutral because you have both a long and a short option that cancel each other out.
- Positive Delta – Call prices rise when the stock price increases, which benefits the call buyer. Conversely, call prices fall when the stock price decreases, which is not good for the call buyer.
- Positive Gamma – A long call’s position delta gets closer to +100 as the stock price increases and closer to 0 as the stock price decreases.
- Negative Theta – The extrinsic value of options decays as time passes, which is detrimental to a call buyer
- Positive Vega – Volatility is a measure of how much a stock price fluctuates in percentage terms, and volatility is a factor in option prices. As volatility rises, option prices tend to rise if other factors such as stock price and time to expiration remain constant. Since a bullish split-strike synthetic position consists of one long call and one short put, the price changes very little when volatility changes if the stock price is between the strike prices. In the language of options, this is a “near-zero vega.” Vega estimates how much an option price changes as the level of volatility changes and other factors are unchanged. However, if the stock price is above the strike price of the call, then a change in volatility will have a greater impact on the price of the call than on the price of the put. As a result, when the stock price is above the strike price of the call, the net price of a bullish split-strike synthetic position will rise when volatility rises and fall when volatility falls. Similarly, if the stock price is below the strike price of the put, then a change in volatility will have a greater impact on the price of the put than on the price of the call. As a result, when the stock price is below the strike price of the put, the net price of a bullish split-strike synthetic position will decrease when volatility rises and rise when volatility falls.
Synthetic Long Call Option Strategy
Profit and Loss Calculations
- Max Profit Potential: Infinite
- Max Loss Potential: Infinit
- Breakeven = Strike Price +/- [ the credit OR debit ]
- Estimated Probability of Profit: Generally between 50-60%.
Synthetic Long Call Option Strategy
Risk of Early Assignment
- While the long call in a bullish split-strike synthetic position has no risk of early assignment, the short put does have such risk. Early assignment of stock options is generally related to dividends, and short puts that are assigned early are generally assigned on the ex-dividend date. In-the-money puts whose time value is less than the dividend have a high likelihood of being assigned. Therefore, if the stock price is below the strike price of the short put in a bullish split-strike synthetic position (the lower strike price), an assessment must be made if early assignment is likely. If assignment is deemed likely and if a long stock position is not wanted, then appropriate action must be taken. Before assignment occurs, the risk of assignment can be eliminated in two ways. First, the entire spread can be closed by selling the long call to close and buying the short put to close. Alternatively, the short put can be purchased to close and the long call can be kept open.Potential position created at expiration
Synthetic Long Call Option Strategy
Management and Adjustments
- With premium selling strategies, defensive tactics revolve around collecting more premium to improve our break-even price, and further reduce our cost basis.
- Close a synthetic long call strategy before expiration. If you remain in this position until expiration, you will probably wind up buying the stock at strike X one way or the other.
- If the stock is above strike X at expiration, you will want to exercise the call and buy the stock. You will be able to buy the stock at the strike price ( which is lower than the actual price )
- If the stock is below strike X at expiration, the stock will be out of the money on the put option. Remember that when you buy a call, you want the stock price to go up. If the stock is below the strike price of the put, you will most likely be assigned on the put and be required to buy the stock.
Option Basics
Tips and Tricks
A Synthetic Long Call Option Strategy will benefit from :
- Ideal strategy if you expect a dramatic increase in a stock
- Need to have the direction of the trade correct!
- Setting up in periods of high IV
- Take profits early at 25-50%