This strategy is a mix of underlying and a put option. I.e. a put option buyer already has a position in the underlying. He holds the stock for long term with the aim of reaping the benefits of price rise, dividends, bonus rights etc. To avoid any intermittent losses because of the fall in stock prices, the owner of the stock also buys a put option. If the price of the stock falls, put option acts as insurance.
In case the price of the stock falls, the option buyer can exercise the Put Option and his profit in the options is the difference between strike price and spot price. The lower the stock falls the higher the profit from options.
This strategy looks like buying a Call Option since profit is unlimited and loss is limited to put option premium. Therefore this strategy is called a Synthetic Call. In simple buying of a Call Option, there is no underlying position in the stock but is entered into only to take advantage of price movement in the underlying stock.
Let’s consider an example to understand synthetic long call clearly.
Mr Shashank has bought 500 shares of Infosys at Rs. 940 per share. He also bought 1 lot put option of strike 940 on 23 October 2017 at a premium of 16Rs/-
|Payoff from Stock
(current price-bought price)
|Put Option Payoff
As seen from the above table, when the stock rises high, the profit is unlimited. Higher the stock price, higher the profit. If the stock falls, the loss is limited to the premium paid for the put option.
Since the payoff diagram resembles the payoff diagram of a call option, it is called synthetic long call.