In this strategy, investors and traders purchase a stock because we feel bullish about it. But what if the price of the stock goes down? As an investor you wish you had some insurance against the price fall. So buy a Put on the stock. This gives you the right to sell the stock at a certain price which is the strike price. The strike price can be the price at which you bought the stock (ATM strike price) or slightly below (OTM strike price).
In case the price of the stock rises you get the full benefit of the price rise. In case the price of the stock falls, exercise the Put Option (remember—Put is a right to sell). You have capped your loss in this manner because the Put options stops your further losses. It is a strategy with limited loss and (after subtracting the Put premium) unlimited profit (from the stock price rise). The result of this strategy looks like a Call Option Buy strategy and therefore is called a Synthetic Call!
But the strategy is not Buy Call Option (Strategy 1). Here you have taken an exposure to an underlying stock with the aim of holding it and reaping the benefits of price rise, dividends, bonus rights, etc. and at the same time insuring against an adverse price movement.
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.
When to use: When the ownership is desired of stock yet investor is concerned about near-term downside risk. The outlook is conservatively bullish.
Risk: Losses limited to Stock price + Put Premium-Put Strike price
Reward: Profit potential is unlimited.
Break-even Point: Put Strike Price+ Put Premium + Stock Price—Put Strike Price
Mr. XYZ is bullish about ABC Ltd stock. He buys ABC Ltd. at current price of Rs. 4000 on July 4. To protect against fall in price of ABC Ltd. (his wish), he buys an ABC Lrd. Put option with a strike price Rs. 3900 (OTM) at a premium of Rs. 143.80 expiring on July 31.
Put Strike +Put Premium+ Stock Price—Put Strike
= (Rs. 3900+ Rs. 143.80+ Rs. 4000-Rs. 3900)
= Rs. 4143.80
This is a low risk strategy. This is a strategy which limits the loss in case of fall in market but the potential profit remains unlimited when the stock price rises. A good strategy when you buy a stock for medium or long term, with the aim of protecting any downside risk. The pay-off resembles a Call Option buy and is therefore called as Synthetic Long Call.