Dawn Pennington

Synthetic Call Options Similar to Real Deal

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While we all know that trading options provides unbeatable leverage and potential returns that straight buy-and-hold investors can only dream about, sometimes simply buying a call or a put option is only the first step to truly harnessing the power of the options markets.

It's possible to use options to simulate a long stock position. We can also use a combination of stock and call options to replicate the returns of both long and short put options.

To complete the trifecta of embracing the enhanced risk-vs.-reward scenarios that can accompany synthetic investments, today let's talk about creating synthetic calls.

First, let's talk about synthetic long calls.

By buying a put option and buying the underlying stock in a 1-to-1 ratio (that is, one options contract per 100 shares of stock), you create a long call option and, thus, recreate the risk/reward scenario.

If you buy an XYZ Oct 40 Put on its own, without the long stock, then you're looking for the stock to finish below $40 on that third Friday in October. But with a synthetic call strategy, you still buy that Oct 40 Put, but with the expectation that the stock (that you hold long) will finish above that $40 strike price.

So, why not just buy an Oct 40 Call if you're bullish on the stock? You could, but with the synthetic strategy, the put actually acts as a hedge in case your share price goes down. Now, you're actually counting on the stock to go up, just like you would as a stock investor, but the put option you also bought gives you a different way to profit.

So, you may buy the stock at $45 and spend $2.50 on that put option at the $40 strike. If the stock goes up, the put becomes worthless and you've spent $2.50 a share on insurance during the life of the option contract. You'd need for the stock to reach $47.50 to "break even" on the trade ($45 + $2.50) and anything higher is your profit. If the stock soars on some great news, your gains can be unlimited, like with a traditional long call.

But if the stock drops to $40, that put becomes an in-the-money option. The lower the shares drop, the deeper in-the-money the puts become. Yes, that means the long stock position becomes less valuable, but the put gives you the right to "put" your long stock to the person who is short the put at the strike price.

So, you would put your $45 stock to the option-writer at $40 a share, which caps your losses at $5 per share -- and that's your maximum loss.

Either way, as the owner of the shares, you are entitled to any dividends it may pay for as long as you are a stockholder.

Now let's discuss the synthetic short call position.