Updated: 11/01/2023

Mastering Options Trading with Synthetic Call Options

options trading basics 1
.18 Sep 2023
author avatar image Chad Smith

Table of Contents

Mastering the art of options trading requires an understanding of its fundamental aspects, a diligent study of its advanced techniques and strategies, and the application of effective risk management. This comprehensive examination aims to provide an in-depth understanding of options trading, beginning with its core concepts, terminologies and distinction from other forms of trading.

One technique at the forefront of this study is the synthetic call options strategy. The creation and components of synthetic call options and how they compare to traditional call options will be thoroughly explored. Furthermore, the practical applications and the ways in which seasoned investors leverage the benefits of synthetic over traditional options for significant returns would be highlighted.

Understanding Options Trading

Options trading is a type of derivative trading that allows the trader to purchase or sell a security at a pre-determined price, known as the strike price, on or before a specified date, known as the expiration date. Options come in two types – calls and puts. Call options signify the right (but not the obligation) to buy assets, while put options give the option holder the right to sell. Options can be traded on a number of underlying securities, including stocks, ETFs, and indices.

Options Trading vs Other Forms of Trading

In comparison to other forms of trading like futures trading or stock trading, options trading can offer higher profitability through leverage. It provides more strategic alternatives as one can speculate the direction of the market, hedge against risk, or create income through writing options. However, these potential rewards do come at a cost. Options are complex instruments and require a significant amount of understanding and knowledge. If utilised improperly or without a sufficient comprehension, the risk of financial loss can be significant.

The Concept of Synthetic Call Options

In the field of options trading, synthetic positions are often used to emulate the risk/reward attributes of a particular strategy without actually owning the strategy. One such synthetic position is the synthetic call options strategy. A synthetic call, or synthetic long call, is created by buying a certain stock and simultaneously buying a put option. The objective is to emulate the payoff of a long-call option.

Risks and Rewards of Synthetic Call Options Strategy

However, like every trading strategy, this strategy also comes with its inherent risks and rewards. The reward in a synthetic call option strategy is virtually unlimited because the strategy profits from a rise in the underlying stock price. On the other hand, if the stock price falls below the strike price of the put option, the maximum loss is capped at the difference between the stock price paid and the strike price, less the premium received. The most significant risk is of the stock price not moving, or moving very minimally. In this case, the trader will lose the entire premium.

Trading options using the synthetic call strategy can be an effective financial instrument to protect oneself from potential losses and capitalise on the market’s positive movements. However, it requires judicious use and an in-depth understanding of its potential risks and rewards.

Image of a person analyzing options trading strategies

Exploration of Synthetic Call Options

Put simply, synthetic call options involve a long position in the underlying asset, coupled with a long position in a put option. Even without the direct purchase of a call option, this strategy can mirror its payoffs. Implementing the synthetic call strategy is a common approach when an investor harbours bullish sentiments towards the market but holds uncertainty regarding the immediate trajectory of the underlying asset.

Components of Synthetic Call Options

The concept of synthetic call options hinges upon the principle of put-call parity. The put-call parity theorem states that the cost of a call option is equal to the cost of a put option plus the underlying price, minus the strike price and interest expense. This essentially replicates the payoff structure of a call option with the use of a put option and the underlying asset.

Comparison with Regular Call Options

While a synthetic call mimics the risk-return attributes of a call option, its trading liquidity and execution are distinctive. Normal call options have fixed expiry dates and are usually traded at a premium over the spot price of the underlying instrument. On the other hand, a synthetic call option doesn’t require paying upfront premiums, thereby reducing out-of-pocket expenses for the trader. Moreover, these synthetic constructs can be tailored to meet the individual time frames and risk levels of each investor.

Benefits of Synthetic Call Options Over Traditional Call Options

There are several potential benefits in opting for synthetic call options over traditional call options. Firstly, there are more opportunities to make adjustments in a synthetic call position, making it easier to respond to changing market conditions. This gives traders a chance to realign their option contracts according to the directional movements in the market, providing a potentially higher degree of flexibility.

Secondly, synthetic call options offer a vehicle for leveraging an investor’s return potential on investment due to their structure. Comparatively, holding a long position in a stock limits the return on the capital gains and dividends that the stock can provide.

Thirdly, the pricing models of synthetic calls are generally simpler and more transparent than those of traditional call options, which often incorporate complex computations for volatility skews and risk margins.

Last, synthetic call options can be designed to optimise tax efficiency given that taxes on derivatives can be delayed until the derivative is sold or expired. Traditional call options, on the other hand, may have tax implications that are less favourable for the trader.

Navigating Options Trading via Synthetic Call Options Strategy

Options trading often involves the strategic use of a synthetic call option for capitalising on volatility upsurges and potentially boosting returns. This strategy is fitting for investors predicting brief directional trends or abrupt price movements in the market. Properly administering synthetic positions requires a seasoned comprehension of the interplay between puts and calls, coupled with rigorous risk management. By adopting an apt synthetic call options strategy, traders have the opportunity to generate appealing returns and balance risks, while leveraging the adaptability provided by synthetic contracts.

Illustration of synthetic call options strategy with arrows representing profits and risks

Practical Application of Synthetic Call Options

A synthetic call option, also termed a synthetic long call, is a trading manoeuvre employed by investors to mimic the payout of an actual call option. It comprises the concurrent acquisition of a specific stock and a put option. When implemented skilfully, it allows the investor to replicate the returns typical of a genuine call option without the need to own one.

Achieving a Synthetic Call Option

To construct a synthetic call option, a trader needs to perform two steps. Firstly, he/she needs to buy the underlying asset. Secondly, the trader needs to buy a put option on the same asset. The strike price of the put option should be the same as the purchase price of the underlying asset. This combination of a long put and long asset position is the basic structure of a synthetic call.

Advantages of Synthetic Call Options

Synthetic call options offer a number of advantages over traditional call options. One of the primary advantages is cost-effectiveness. Synthetic call options are usually cheaper to set up than buying a standard call option. They also offer more flexibility in terms of adjusting the strategy to market conditions.

Another advantage of synthetic call options is that they allow traders to benefit both from price appreciation of the underlying asset and protection against downward price movement. This makes synthetic call options an efficient hedging tool.

Case Study – The Use of Synthetic Call by Renowned Traders

Notable investors have successfully utilised the concept of synthetic call options in real-world trading situations. An example of this is the famous strategy used by hedge fund manager Nassim Taleb. To protect against extreme market movements, Taleb would hold a majority of his portfolio in risk-free bonds, while investing a small percentage in far-out-of-the-money synthetic call options. This strategy allowed Taleb to benefit from extreme market movements, while effectively hedging his risk.

Another Application of Synthetic Call Options

More conservative investors may also use synthetic call options as a downside protection strategy. By buying a stock and a put option, these investors can limit their losses in case the stock price falls while allowing them to profit if the stock price increases. This strategy allows investors to participate in the upside movement of a stock while limiting their risk on the downside.

Asset Protection with Synthetic Call Options

Yet another application of synthetic call options lies in protecting a large, concentrated stock position against the market downside. If an investor owns a large number of shares of a single stock, they could buy put options on the stock to protect against a significant decline in the stock’s price. This would in effect create a synthetic call option position, securing the investor’s portfolio against severe market downturns.

Wrapping-Up

To conclude, synthetic call options stand as a versatile, cost-effective and efficient mechanism, widely embraced by institutional investors and individual traders alike. When precisely utilised, they may present advantageous returns whilst efficiently defending against prospective losses.

A visual representation of a synthetic call option strategy, showing the combination of buying a stock and a put option to achieve similar returns as a traditional call option.

Risk Management Strategies in Options Trading

Diving into the foundations, a synthetic call option is a trading approach where an investor, harbouring a long position in a share, procures a put option of the identical stock. Altogether, the long stance on the share and the long stance on the put option competently replicate the yield of a long position on a call option, consequently deemed as a synthetic call option. The rationale here is to safeguard oneself from potential losses that may transpire if the rate of the underlying share descends.

Risk Management with Synthetic Call Options

While synthetic call options provide intriguing trading possibilities, they equally warrant sound risk management strategies. It’s crucial to understand that a put option loses value as the underlying stock increases in price, and this cost of the put option will reflect as a loss if the stock’s price climbs during the contract period.

To mitigate this risk, always have a good idea about the correlation between the derivative and the underlying asset. Consider the implied volatility and deeply understand the pricing models of options. This understanding helps to estimate potential losses and take appropriate risk management steps.

Planning for Different Trading Conditions and Markets

Success in synthetic options trading strategy not only depends on the underlying asset’s anticipated directional move but also relies on an understanding of the different trading conditions and markets. For example, in a sideways market, the synthetic options strategy might not be as effective because the cost of the put option might nullify any profits garnered.

On the other hand, during times of high volatility, synthetic options can prove quite valuable. The increased volatility could heighten the chances of the underlying asset’s price reaching the option’s strike price, leading to higher potential profits.

Creating an Effective Risk Management Plan

An effective risk management plan for professionals trading in options begins by understanding key market indicators, economic factors influencing stock prices, and trends driving the market. It’s important to set a trading limit for each session based on the available capital to invest and potential impacts on personal finance if the market does not go as anticipated.

Moreover, consistently assessing and updating your strategies in accordance with the changing market conditions forms the cornerstone of a good risk management plan. Strategies should be reassessed quarterly or semi-annually to incorporate changes and make any necessary adjustments.

Monitoring Performance and Adjusting Your Strategies

It’s not enough to simply create a risk management plan; you must also monitor its effectiveness. Regularly review your investment results, and analyze the accuracy of your predictions, and the actual profit/loss from each trade. Evaluating your trading performance will help identify strategies that work well for your financial situation and market condition and will allow you to fine-tune strategies that may not be working as expected.

In the complex world of options trading, the allure of limitless profit potential is often counterbalanced by the prospect of significant losses. This is especially true when dealing with strategies such as synthetic call options. As such, it is absolutely imperative to establish a comprehensive risk management plan.

A person analyzing options trading strategies on a computer screen

Advanced Techniques in Synthetic Call Options Trading

A synthetic call option strategy is an advanced investment approach that involves the simultaneous purchase of a security and a put option. The attractiveness of this strategy arises from the fact that it allows an investor to gain exposure to the upside potential of an asset without technically owning it – thereby earning it the ‘synthetic’ label. Such trading strategies are commonly utilised in volatile markets since they provide a means to temper downside risk, whilst still allowing traders the opportunity to capitalise on upward price movements.

Components of Synthetic Call Options

The key components of synthetic call options are the underlying security (such as a stock or an index), and the put option. The put option gives the buyer the right, but not the obligation, to sell the underlying security at a predetermined price, known as the ‘strike price’. This means that if the price of the underlying security falls below the strike price, the holder of the put option can sell the security at the higher strike price, limiting their losses.

Parameters of Synthetic Call Options Trading

Several factors can influence the pricing and potential profitability of synthetic call options. These include the price of the underlying security, the strike price of the options, the time until the option expires, and the implied volatility of the security. It’s crucial for traders to consider all these factors when deciding on a synthetic call options strategy. Moreover, understanding these parameters can help traders to optimize their strategies for higher returns.

Benefits of Synthetic Call Options Trading

One of the significant advantages of synthetic call options trading is the ability to gain exposure to an underlying security without having to own it. This can be particularly beneficial in volatile markets, where owning the actual security could expose the trader to substantial risk. Synthetic call options also offer potentially unlimited upward profit potential, since the price of the underlying security could, in theory, rise indefinitely.

Risks Associated with Synthetic Call Options Trading

While synthetic call options offer some distinct advantages, they also come with their own set of risks. The premiums for options contracts can be expensive, especially for popular or volatile securities. There is also the risk that the price of the underlying security will collapse, leaving the trader with a worthless option and a significant loss. As a result, it’s critical for traders to thoroughly analyze and understand these risks before they dive into synthetic call options trading.

Advanced Techniques in Synthetic Call Options Trading

Advanced traders might consider a variety of more complex strategies for trading synthetic call options. For example, a risk reversal strategy involves buying an out-of-the-money put option while simultaneously selling an out-of-the-money call option. This heavily skewed risk profile can lead to significant profits if the trader’s prediction about the direction of the underlying security’s price movement is correct.

Another example is the long straddle strategy, which involves buying both a call and a put option with the same strike price and expiration date. This could potentially profit from extreme price movements in either direction, making it particularly suitable for volatile markets.

These advanced synthetic call options trading strategies and others are complex and involve high risk. It is therefore crucial for anyone interested in these techniques to undertake thorough research and possibly seek professional advice before implementing them. As with any investment strategy, understanding and managing risk is key to achieving success.

Illustration of synthetic call options trading strategies.

The all-encompassing nature of this discourse has offered an in-depth exposure to synthetic call options and how they can be skillfully used to maximise returns. The importance of a shrewd risk management strategy as a vital component of successful trading is underscored.

Through the exploration of diverse trading conditions, this discourse provides a framework for integrating effective risk management into a trading plan. Delving into the more advanced techniques unlocks the potential for higher returns. The advanced strategies, their implications, and the factors influencing these techniques are appropriately delineated, marking the terminus of an exhaustive journey into the fascinating world of synthetic call options trading.

author avatar image
Chad Smith

Chad Smith is the Director of Research & Analysis here at ForexBrokerListing.com. Chad previously served as an Editor for a number of websites related to finance and trading, where he authored a significant number of published articles about trading and the impact of technology in transforming investing as we know it. Overall, Chad is an active fintech and crypto industry researcher with more than 15 years of trading experience, and you can find him teaching his dog how to trade in his free time.