More Thoughts on the "Synthetic" Covered Call Strategy
I described the Synthetic" covered call strategy
(a bull call spread) in some detail two months ago (6/24/05 TSM
report and 7/29/05 TSM report). Since then we've made a
number of trades utilizing the method so I thought that it would be
worthwhile to look at other features of the trade. Specifically, I want to
look at the array of possibilities that present themselves for a stock (here
POT) and some of the criteria used to choose between them.
POT had been making a bullish run for several
months. Recently, though, it's been pulling back into the area marked in green.
In today's economic environment, POT's sector, metals & mining, has rotated into
favor as well. The question a trader asks: Does one want to commit cash to buy
shares of such a pricey stock? The "synthetic" covered call offers an
alternative requiring far less cash.
Ideally, we would put the trade on just as its pullback reversed itself, but
here we'll look at the opportunities that present themselves well after the
pullback reversed on 8/11/05: POT closed at $113.77, up $2.11 for the day.
Let's say that we normally trade 500 shares of stock. In POT's case,
probabilities favor it climbing further from here. I could just buy 500 shares
at $56,885. Instead though, I could opt to buy one of the Sept calls shown in
the table below, let's say 5 contracts of the $100 call at $14.80 per share or
$7,400 (500 x $14.80). Buying a call contract forces the seller to sell me 500
shares of POT at $100 per share over the next 35 days, and for this right, I pay
a $14.80 premium. My breakeven point for the call is $114.80. The benefit:
much less cash required for the position; the downside: my breakeven point is
over a dollar higher than today's close.
I could instead create a "covered" call. That
is, I could buy the 500 shares then sell the Sept $115 call for $3.4 a share
($1,700 for the 500 shares). Shorting the call obligates me to provide the
buyer my 500 shares anytime over the next 35 days for $115 per share; hence, the
short call is covered by the shares. The benefit: I've reduced my stock basis
from $113.77 to $110.37 ($113.77 - $3.40) and lessened the cash needed to
$55,185 ($56,885 - $1,700); the downside: it's still a lot of cash, and I've
limited my upside to $115, i.e., I have to provide the 500 shares at that price,
even it its price rises to $200 by the time of expiration.
Let's now consider what I think is a better
alternative than the three positions described above, the "Synthetic" covered
call. Instead of covering a short call with shares that I own, I cover it with
a long, deep in-the-money call that provides me the shares by expiration. One
buys the lower valued strike and sells a higher valued one, both expiring in the
same month. Because a whole range of strike prices are available for each of
several months in the future, there are a range of possibilities for "synthetic"
The following table presents the possibilities
available to POT utilizing September and December Calls, the first expiring in
35 days, the second in 126 days. Each column--starting with the
fourth--represents data for the two calls joined in black or grey, e.g., column
four is the long $95/short $100 combination, while column seven is the long $95/
short $115 combination. The first position requires $2,650 to put on, has an
effective share cost of $100.3 but is guaranteed to lose 5.7 percent because of
the spread in the bid/ask prices. The second position fares better. It
requires $8,000, has an effective share cost of $111.00, and returns a maximum
profit of 25 percent over the next 35 days if POT closes above $115. One gets
better yields by increasing the effective price, but at the same time, the risk
of winning falls. I prefer the $105/$115 combination: 42.9 percent profit
potential, $3,500 cash necessary to set up the position, $112 effective price
with $115 maximum cap. In essence, I put up $7 to earn $3 but have some
downside protection. Going further out in time to December appears to give
better performance, but I can place three, one-month trades over the time it
takes to make a single three-month trade.
The benefit of the "Synthetic" covered call: far
less cash required ($3,500 for $105/$115 combination), some downside protection
with a reduced effective share cost ($112 versus current $113.77), and a cap on
any possible loss (here my $7/share cost); the downside: size of the win is
capped by the strike price of the higher strike (here $115).
One can improve the performance by going long the
lower-price strike when POT hits our TSM buy point, but waiting for this initial
thrust up to play out before shorting the higher-price strike. This approach is
called "legging" into the trade.
"Synthetic" Covered Call for GOOG (6/20/05)
Several of you asked about the option approach that I outlined for taking advantage of GOOG's recent pullback. I'll go into that
trade further here, since GOOG presents problems for most of us, because it's both expensive and volatile (~$280 a share). On
the other hand, fundamentals are great; earnings estimates are continually being increased; value remains, even at these prices;
and the technical pullback pattern is classic. Option approaches offer an ideal fit for this situation, as they can both limit the cash
needed and do a better job of controlling the downside risk. As evidence, contrast three approaches: buying the stock itself,
buying the stock and selling Calls ("covered" Calls), and buying in-the-money Calls while selling at-the-money Calls.
GOOG has been on a bullish tear since coming public
last year, even more so since forming its breakaway
gap (left side of chart) last month. Over the last
two weeks, however, it's been consolidating those
gains in six days of lower highs. That trend
reversed when a bullish, "hammer" candle formed last
Wednesday at the support of its 20-day moving
average. That pullback has now been followed by two
days of reversal.
Let's contrast the three approaches to entering a
GOOG position (two utilizing options): (1) buying
100 shares of GOOG outright, (2) buying the shares
and selling 1 Call contract (July $280 strike)
against them in a conventional "covered" Call, and
(3) combining 2 long July $240 strike Calls with 2
short July $280 strike Calls in what I'll call a
"synthetic" covered Call. Note, I executed two
calls in the last because the cash required is far
less: $28,030 for the stock position, $25,540 for
the "covered" Call, and $4,760 for the "synthetic"
GOOG daily chart
I could have executed the following
trades just before Friday's close (6/17/05) when
GOOG closed at $280.3: long the $240 Call at a cost
of $58.7 per share (ask price) in 100 share
contracts and short the $280 Call, generating a
$34.9 per share premium (bid price). The
"synthetic" covered Call buys 2 $240 Calls at a
total cost of $117.40 per share or $11,740 for the
two contracts and then sells 2 $280 Calls for a
premium of $69.80 or $6,980 for the two contract.
Total cost for the "synthetic" covered Call position
is $4,760 ($11,740 - $6,880).
The table below shows the profit
potential for the three strategies over a GOOG price
range between $200 and $340 at the July expiration
in 26 days (July 15, 2005). Several points are
obvious: (1) both option approaches remain
profitable even if GOOG drops by $10 to $270 at
expiration ($267.43 is the technical stop), while
the stock purchase loses money there (option
strategies control risk better); (2) both option
approaches limit the upside, not so for the stock
purchase; (3) the "synthetic position involves less
initial cash and gives the superior return. Note,
the last column provides the option deltas for Call
strikes falling between $200 and $340; this is also
the probability that the Call will finish in the
money, i.e., there is a 0.15 probability that GOOG's
price will reach $310 by expiration.
*Find Excel program that generates this table at the option page under synthetic covered call.
The chart to
the right shows the profit/loss generated by
the three strategies over the range of
potential values at expiration. Stock
ownership in blue varies linearly; the
"covered" call in yellow is capped on the
high side; the "synthetic" call in red is
capped on both the high and low sides.
Again, the last requires far less cash in
the beginning, offers downside risk control
that the other two don't, and generates a
positive return even if the stock should
drop $15 by expiration.
I would use
the stock as a trigger for unwinding the
position, i.e., if GOOG's price fell below
$267.43, I would unwind the position.
"Synthetic" Covered Call (7/29/05)
Several of you have asked me to
explain this option strategy. Just what is a
"synthetic" covered call and why should the average
trader be interested? Well let me answer those
questions here and in the process add some
additional information. Several option tools and
valuable informational links can be found at the
TSM option page.
A full introduction to options and the host of
strategies we'll be implementing here can be found
in my new book ("Options: What are They and How
can the Average Investor/Trader Profit from Their
Use?") at this same link.
A covered call, you'll remember,
is a conservative strategy used to earn income from
stock holdings and at the same time reduce the risk
somewhat of holding the shares. For example, say
you owned 100 shares of KBH and paid $82.80 at
today's open. You could have sold the September $85
call and received $2.90 a share for the 100 share
contract. That would have obligated you to sell
your shares for $85 by September 16 (50 days from
now). Your profit would be limited to $5.10 ($85 -
$82.80 + $2.90) a share or 6.4 percent earned over
50 days (46.7 percent annualized). That's not bad
for a pretty safe trade, but it would require a cash
outlay of $79.90 per share ($82.80 - $2.90). Your
downside is slightly protected by the option premium
earned, i.e., over the next 50 days, the price of
KBH could drop to $79.90 and you would break even,
while someone owning just the shares would be down
$2.90 a share. The downside, other than requiring a
big cash outlay for the stock, is that the profit is
capped to the upside. If KBH climbs to $100 over
the next 50 days, you're still forced to sell at $85
a share. Let's look at another strategy designed to
accomplish the same thing but with a higher return
and requiring less cash.
The "synthetic" covered call
(really a debit Bull Call Spread) substitutes buying
a deep in-the-money call for stock ownership. For
KBH, instead of buying the stock itself, we bought
the September $70 call for $13.80 a share ($1,380
per 100 share contract) and sold the September $80
call for $5.70 a shares ($570 per 100 share
contract). Both expire in 50 days, and both are
in-the-money right now. My total cash outlay is
$8.10 per share ($4,050 for 5 contracts). Over the
next 50 days, I'll receive max profit if KBH stays
above $80 per share. It's $1.90 per share ($950 for
5 contracts) or 23.5 percent (171.2 percent
annualized). Further, our max loss is capped at
$8.10 per share (usually less because a technical
stop is used employing the underlying stock), and
our max profit is capped at the $80 stock price.
Compare this approach with paying $41,290 ($82.58
per share shortly after the open) for 500 shares of
the stock. The following Excel table calculates the
profit potential of a "synthetic" covered call
position. It's available at the
TSM Option page.
Just fill in the information embedded in the red
Once this table is filled in the following table is
generated. Profit potential is calculated for stock
ownership, the traditional covered call, and the
"synthetic" covered call over a range of potential
prices at expiration (here from $67 to $97).
Profit/loss charts are also provided.
There's two further pieces of information important
to this strategy. How do time to expire and the
size of implied volatilities impact the return?
Recall an option's implied volatility is directly
related to its premium. It changes with supply and
demand, as well as several of the option's inherent
characteristics. An option's implied volatility is
the range the the stock is expected trade over the
next year, e.g., a stock priced at $100 a share with
its option's implied volatility at 35 percent is
expected to trade between $65 and $135 (+/- 35
percent) over the next year. As shown in the
following table--developed for the KBH "synthetic"
covered call--value falls with this strategy when
implied volatilities decrease or expiration time
Let's now look at a real world example of the
"synthetic" covered call, the GOOG trade we entered
on 7/14/05. The following table summarizes our
could have bought 200 shares of GOOG on 7/14/05 for
a total cost of $60,950 when it was climbing every
day in anticipation of its earning report.
Instead, we established the Aug 270/300 "synthetic"
covered call at 6 contracts for a total cost of
$11,880. Both had profitable 1st half trades: +2.40
percent and +12.1 percent, respectively. But both
trades turned bad as analysts were less enthused by
the earnings report. On 7/29/05, the 2nd half of
both trades were stopped out: a 14.81 percent loss
for the shares and a 10.10 percent loss for the
option position. In summary, one needed far less
cash for the option position and even though the
trade was marginal, the option trade made money
($240) while the stock trade lost money ($756).
Enough said as to why I prefer the "synthetic"
covered call to regular stock ownership, especially
when the implied volatilities are favorable.