Synthetic
Call
Description
This
is an investment strategy that mimics the payoff of a call option. A synthetic
call is created by purchasing the underlying asset, selling a bond and
purchasing a put option. The strike price on the put option is equal to the
face value of the bond, which serves as the exercise price of the synthetic
call.
A
synthetic call produces the same overall payoff as a call option. The synthetic
call will finish in the money when the price of the underlying asset is greater
than the face value of the sold bond at the time of expiration. It will be
out-of-the-money when the value of the bond is greater than that of the
underlying asset. When the synthetic call is in the money, the profit is the
difference between the price of the underlying asset and the face value of the
bond. If the call finishes out of the money, the put option absorbs the loss
from the underlying asset, with the exercise price of the put paying for the
bond.
Market
Opinion
Bullish.
P/L
When
To Use
Use
this strategy when you want to buy a stock and protect its downside.
Example
XXXX
is trading at $35.50 on June 1, 2011.
Buy
1,000 shares of stock at $35.50.
Buy
10 August 2011 35 strike puts at $2.55.
Benefit
This
strategy is low risk, while offering unlimited upside potential. It protects
your stock from a price decline.
Risk
vs. Reward
Minimal
risk because of a capped downside, with the reward of an unlimited upside
potential.
Net
Upside
Unlimited
upside potential.
Net
Downside
Stock
price plus premium minus put strike price.
Break
Even Point
Put
strike plus put premium plus stock price minus put strike.
Effect
Of Volatility
N/A
Effect
Of Time Decay
The
final month has time decay for the put you bought. You benefit from buying one
month longer on the put to mitigate this effect.
Alternatives
Before Expiration
To
stem a loss, close the position. If the stock drops under the stop loss, sell
the stock and keep the put or close out the entire position.
Alternatives
After Expiration
Close
position by selling the stock or put, or both.
