PROTECTIVE CALL / SYNTHETIC LONG PUT
This is a strategy wherein an investor has gone
short on a stock and buys a call to hedge. This is an opposite of Synthetic
Call (Strategy 3). An investor shorts a stock and buys an ATM or slightly OTM
Call. The net effect of this is that the investor creates a pay-off like a Long
Put, but instead of having a net debit (paying premium) for a Long Put, he
creates a net credit (receives money on shorting the stock). In case the stock
price falls the investor gains in the downward fall in the price. However, incase
there is an unexpected rise in the price of the stock the loss is limited. The
pay-off from the Long Call will increase thereby compensating for the loss in
value of the short stock position. This strategy hedges the upside in the stock
position while retaining downside profit potential.
When to Use: If the investor is of the view that the markets will go down (bearish)
but wants to protect against any unexpected rise in the price of the stock.
Risk: Limited.
Maximum Risk is Call Strike Price – Stock Price + Premium
Reward: Maximum
is Stock Price – Call Premium
Breakeven: Stock Price – Call
Premium
Example :
Suppose ABC Ltd. is trading at Rs. 4457 in June.
An investor Mr. A buys a Rs 4500 call for Rs. 100 while shorting the stock at
Rs. 4457. The net credit to the investor is Rs. 4357 (Rs. 4457 – Rs. 100).
Strategy
: Short Stock + Buy Call Option
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Sells Stock
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Current Market
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4457
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(Mr. A receives)
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Price (Rs.)
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Buys Call
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Strike Price (Rs.)
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4500
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Mr. A pays
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Premium (Rs.)
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100
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Break Even Point
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4357
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(Rs.) (Stock Price
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– Call Premium)
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The
payoff schedule|
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Payoff from the
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Net Payoff from
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ABC Ltd. closes at
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stock (Rs.)
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the Call Option
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Net Payoff
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|
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(Rs.)
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(Rs.)
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(Rs.)
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|
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4100
|
357
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-100
|
257
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4150
|
307
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-100
|
207
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4200
|
257
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-100
|
157
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4300
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157
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-100
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57
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4350
|
107
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-100
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7
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4357
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100
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-100
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0
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4400
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57
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-100
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-43
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4457
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0
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-100
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-100
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4600
|
-143
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0
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-143
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4700
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-243
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100
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-143
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4800
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-343
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200
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-143
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4900
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-443
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300
|
-143
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5000
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-543
|
400
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-143
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The payoff chart (Synthetic Long Put)
+ =
Sell Stock Buy Call Synthetic Long Put
