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The Synthetic Covered Call Options Strategy Explained

The answer is the Synthetic Covered Call.
 

What Is A Synthetic Option Strategy?

A synthetic covered call is an options position equivalent to the covered call strategy (sold call options over an owned stock). It consists of a sold put option.

Synthetic options strategies use bought and sold call and put options to mirror the payoff, risks, and rewards of another strategy, often to reduce complexity or capital requirements.

 

For example, suppose a stock, ABC, is trading at $100. Buying 1000 shares would be expensive ($100,000 or perhaps $50,000 on margin).

 

The same risk and rewards can be achieved by buying an at the money call option (strike price 100) and, simultaneously, selling an at the month put option (exercise price 100).

 

How do we know these are the same trade? By looking at their pay off diagram. It is a fundamental point of options theory that if the payoff diagrams of two strategies are the same, over time, they are the same position.

 

Here’s the stock pay off diagram:
 

 

 

And the ‘synthetic stock’:
 

 

These are identical and don’t deviate over time (in fact the payoff diagrams don’t change at all over time – both positions are theta neutral) and so are the same.

 

But why would you put on this synthetic position? Because it potentially requires much less capital: owning a call option (just the premium) and being short a put option (just any margin requirement) requires less cash up front.

 

What Is A Covered Call?

We’ve covered this elsewhere, but a covered call is one of the most popular option strategies.

 

It involves a short call option – usually out of the money – against an owned long stock position.

 

It’s popular with stockholders wishing to generate income on their portfolio. Selling, say, monthly out of the money (OTM) call options against their stock positions for option premium is attractive, particularly in these low yielding times.

 

Their only risk that their stock gets called away – the stock rises above the sold call strike price on expiry. But even in this scenario the stockholder would still profit – but not by quite as much as if they had not sold the share.

 

Let’s look to an example.

 

An investor owns shares in XYZ, trading at $50 a share, and decides to sell 1 month call options with a strike price of $50, over this holding, receiving premium of $5 a share. This is the classic covered call.

 

Should the stock be below $50 in a month, the investor keeps the $5.

 

If the stock rises above $50 their shares would be called away – in effect sold at $50 at zero profit or loss plus the $5 premium.

 

The only ‘loss’ would be if the price rose over $50 – $60, say. Then the $10 rise would be lost as the investor must sell their shares for $50 rather than $60.

 

Here’s the payoff diagram:
 

 

Many investors believe this loss of potential upside a price worth paying for the chance to enjoy monthly option premiums against already held shares.

 

Why Put On A Synthetic Covered Call?

The question then arises – why both trying to recreate the covered call strategy if it works so well?

 

The answer is, of course, that you may not own the shares. Our investor above already owned the shares. What if you don’t?

 

Well, you could buy the shares and then sell the calls as above. But that requires a significant outlay of capital. What if there was a way to replicate the above whilst reducing this capital requirement to something more reasonable?

 

That’s where the synthetic covered call comes in.

 

How To Construct A Synthetic Covered Call

This is much simpler than you might think. It simply involves selling at the money put options.

 

Let’s go back to our example.

 

This involved owned stock and sold calls with a $50 strike price.

 

We can replicate this by simply selling puts at $50. Note that you don’t need to own the stock (they are so called ‘naked’ puts) and that the puts are at the money with the stock trading at $50.

 

Here’s the payoff diagram:
 

 

Notice that it’s identical to the covered call above.

 

And therefore, using the principle above, the strategies are the same.

 

Advantages Of The Synthetic Covered Call

We’ve mentioned the main reason before: there is no need to own the stock thus, potentially, reducing the position’s capital requirements.

 

Disadvantages Of The Synthetic Covered Call

A ‘naked’ put is very risky: it has almost unlimited downside risk. Should the underlying stock fall heavily losses could be substantial.

 

The position is Vega negative: a rise in volatility would work against position. Unfortunately, the most likely reason for a rise in implied volatility is a sharp fall in stock price – thus exacerbating the losses caused by such a fall.

 

The possibility of large losses could mean that brokers do not allow you to place naked options positions or require a significant margin.

 

Indeed, many options brokers would only consider a cash-secured put write: sufficient cash held to buy the stock should the put expire in the money. This eliminates the main driver for the position: capital requirements.

 

Unlike the covered call the investor would not receive any dividends paid by the underlying stock.

 

Other Points To Note

One Way To Reduce Risk

It is possible to reduce the risk of the synthetic covered call by buying an out of the money put when initiating the trade.

 

This turns the trade into a bull put spread which, as a covered rather than naked position, has a much lower broker margin requirement.

 

It does, however, reduce the net premium earned which may be significant.

 

An Alternative: The LEAP Covered Call

An alternative way to reduce the capital requirements of a covered call is to buy a deep in the money  LEAP  call (ie a long dated call option) in place of the stock, but at a much lower capital requirement.

 

OTM LEAPs have deltas close to 1, and hence behave similarly to the underlying stock. Short dated call options can be sold regularly over the LEAP as though it was the stock.

 

The disadvantage is that LEAPs, unlike stocks, have some intrinsic value which is subject to time decay. All things being equal they will lose value over time (they are theta positive) albeit slowly.

About the Author: Chris Young has a mathematics degree and 18 years finance experience. Chris is British by background but has worked in the US and lately in Australia. His interest in options was first aroused by the ‘Trading Options’ section of the Financial Times (of London). He decided to bring this knowledge to a wider audience and founded Epsilon Options in 2012.

 







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