Options trading can give investors unique opportunities to manage risk and achieve growth. The synthetic covered call is a strategy that combines the benefits of traditional covered calls with no need to own shares in your portfolio. The synthetic covered call strategy uses deep in-the-money calls, requiring less investment, making it ideal for those with a neutral short-term outlook but bullish long-term predictions. Let’s look closer into synthetic covered calls with practical examples and tips.
Key takeaways
- The synthetic covered call strategy is a replication of the traditional covered call strategy. It involves replacing the long stock position with deep-in-the-money calls.
- The synthetic covered call strategy requires a smaller investment and is useful for those who have a neutral to bullish outlook on the asset.
- The synthetic covered call strategy is often used as another term for the poor man’s covered call (PMCC) trade, with sometimes a difference in expiration dates.
What are Synthetic Covered Calls?
First of all, what are synthetic covered calls? We should probably begin with a classic covered call structure to better convey this idea. A traditional covered call involves owning the underlying stock and selling a call option against that stock. This method is popular among investors looking to generate income on their stock holdings while slightly reducing downside risk.
The synthetic covered call strategy tweaks this concept for enhanced efficiency and flexibility. Synthetic covered calls replace the need to own the underlying shares with the purchase of long call options. These options are typically deep in-the-money, offering a similar profit potential to holding the stocks directly but at a fraction of the capital requirement.
This shift from direct stock ownership to utilizing options is what characterizes the synthetic options approach. It allows traders to mimic the payoff of owning stocks without the significant upfront investment.
The structural elements of synthetic covered calls are quite straightforward. At its core, the synthetic covered call strategy involves buying a long call option while simultaneously selling an out-of-the-money call option. The long call stands in for the shares of the stock, which means that the trade has a potentially unlimited upside, while the short call generates income, just like we observe in a classic covered call trade. This combination reduces the overall cost of entering the trade and introduces a leverage component that you normally do not find in conventional stock purchases.
An excellent synthetic covered call example to illustrate this would be a scenario where an investor wants to engage in a stock trading around $900 (for instance, at the time we are writing this article, NVDA). Instead of reserving $90,000 to purchase 100 shares, the investor could opt for a deep-in-the-money call option costing significantly less. For instance, a $700 call expiring in 6 months on NVDA has a price close to $240 at the moment, which means that the upfront capital requirement is only $24,000. This trade offers a similar risk and reward profile as owning 100 shares of NVDA, but it requires less than 30% of the cost.
Furthermore, synthetic covered calls can dramatically lower the capital requirement, offering a strategic advantage, especially in a neutral to bullish market outlook. By utilizing long call options as a surrogate for owning the actual stocks, traders can achieve a similar investment position with less capital, providing leverage that enhances potential returns.
To effectively illustrate the differences between the classic covered call strategy and the synthetic covered call strategy, here’s a comparative table highlighting key aspects:
Understanding Synthetic Covered Calls Through Classic Covered Calls
The best way to explain how a synthetic covered call strategy works is to start with a covered call trade and show you why you may find its synthetic version more appealing. Consider DELL, currently trading at $127.70. Using a classic covered call, an investor may buy 100 shares of DELL and sell a $121 call option, as you can see in our options screener image below:
In this scenario, investing in DELL would mean spending $12,770 for 100 shares. By selling the call option, with bid and ask prices at $8.40 and $8.70, respectively, and taking the midpoint at $8.55, you would receive an $855 premium. Consequently, the net investment required for this classic covered call strategy would total $11,915 ($12,770 – $855).
However, committing $12k might feel too substantial for your current financial strategy. The major burden here comes from the necessity to purchase the stock directly. This operation introduces a significant capital exposure that might not align with your risk tolerance or investment capacity.
We’ll now gradually move from this example to a synthetic call trade to demonstrate a compelling alternative. The synthetic covered call strategy allows you to benefit from a similar market opportunity without directly purchasing the stock. The example in the next section will help us prove our point.
A Synthetic Covered Call Example
Now, let’s keep the same stock as underlying (DELL) and approach it with a synthetic covered call strategy. Again, DELL is trading at $127.70, but this time, instead of buying the stocks outright, we opt for a different route.
We sell a $121 call, just like we did in our classic covered call approach, but we pair this with purchasing a deep in-the-money call option expiring in 6 months. For instance, choosing to buy a $60 call might come with a bid-ask price ranging from $66.30 to $67.10. Settling at a midpoint price of $66.70 means we’d require $6,670 for this leg of the synthetic covered call strategy. This operation significantly reduces the initial capital used – a bit more than 50% less than what would be needed in a standard covered call or even less when accounting for the premium received from the call we sell. Additionally, we will be able to sell more short-term calls for a premium after the first one expires (and gain more income).
The profit and loss (P&L) profile of this synthetic setup mirrors that of a classical covered call, as you can see below:
Note that the P&L profile below only refers to the situation when the first option expires, as is the case for every P&L chart involving options with different expiration dates.
We are still able to mitigate losses if the market turns bearish while keeping profits capped in a bullish scenario. Yet, this outcome is achieved with a substantially lower upfront investment.
Note that, in this synthetic call scenario, you don’t actually own any DELL stock. This means you won’t be eligible for dividends should the company decide to distribute any. However, the main strength of this strategy lies in its flexibility; you can allow the sold call to expire, ideally worthless, and then sell a new one, continuing to generate income from the strategy with a much smaller capital outlay.
Implementing the synthetic covered call example with DELL tells you a lot about the strategy’s efficiency in capital usage and about its adaptability to different market conditions without the necessity of holding the actual stocks.
The Rationale Behind Synthetic Positions in Options Trading
Let us take just one step back to give you a better understanding of why traders lean towards utilizing synthetic options. The number one selling point of synthetic covered calls and other synthetic options is the versatility and the leverage they provide.
Unlike traditional stock holdings, synthetic positions, such as the synthetic covered call strategy, offer traders a way to emulate owning stocks without the significant capital outlay. If you recall, we told you a similar story in our article on the so-called poor man’s covered call (PMCC). In fact, most options traders use the terms “synthetic covered call” and “poor man’s covered call” interchangeably. The story here is the same: you get the benefits of a covered call, at a lower cost. Just so that you know, some websites refer to synthetic calls mentioning the use of two options expiring on the same date.
You are basically using synthetic positions to replicate the profit and loss potential of actual stock holdings while employing less capital.
For example, a synthetic covered call example demonstrates how traders can control a substantial position in a stock like DELL with considerably less money down, using options like a deep in-the-money call instead of purchasing the stock outright. The very first synthetic call example we mentioned on NVDA was even more significant, as it only required less than 30% of the initial capital you’d normally need from buying 100 shares thanks to these synthetic options.
Risk management is another critical advantage brought forth by synthetic options. For instance, let’s go back to the DELL synthetic covered call strategy. The fact that half of your capital is now free could give you other market opportunities to protect your portfolio. You may open a separate trade to buy an OTM put on DELL just in case things go south for you, or you may go long on a VIX-based ETF to create a safety net for your portfolio in times of high volatility.
In Which Cases Should You Go for a Synthetic Covered Call?
So, when should you go for a synthetic covered call strategy? This approach is particularly appealing in scenarios where direct stock ownership doesn’t present an additional benefit, such as in cases where the stock does not pay dividends. It’s an ideal strategy for traders who are more interested in leveraging the price movements of the stock rather than accumulating shares for long-term investment or dividend income.
Traders with smaller accounts will find the synthetic covered call strategy especially attractive. Synthetic options allow for participation in the potential upside of a stock with significantly less capital compared to owning the stock outright. It’s a simple way to utilize leverage more effectively, providing a means to engage in sophisticated options strategies without the large financial commitment usually required.
