Covered calls are a natural bridge and a logical place to start for stock investors looking to transition into options trading.
In this show, we'll explore the different ways to set up and trade synthetic covered calls, focusing on using call spreads versus single-leg short calls.
Hopefully, this will give you some new ideas, and you’ll see that using a covered call synthetic can be a powerful alternative in certain instances.
Covered call strategy
A covered call combines a long stock position with a short call option. You can use covered calls to generate income on long stock while reducing the position’s cost basis. Although covered calls do not eliminate downside risk for the stock, receiving the premium reduces the overall loss potential.
Covered calls have numerous benefits over traditional long stock positions and are an excellent way for stock traders to use options in their portfolios.
Poor man's covered call
The poor man's covered call strategy (PMCC) replicates the structure of a traditional covered call position, but you replace the long equity position with an in-the-money long call option. A PMCC is essentially a diagonal call spread.
This allows you to synthetically create a long stock position with the benefit of options leverage and efficient capital usage.
For example, an $800 stock requires $80,000 of capital to purchase 100 shares. Conversely, a deep-in-the-money, 90 DTE call option may only cost $94.15, or $9415. So, you can control the same amount of shares for much less capial.
You still sell a call option (or a call spread) out-of-the-money above the long call option to lower the position’s cost.
Synthetic covered call
A synthetic covered call is similar to a traditional covered call setup, but you purchase an additional long call option above the short call to create a short call spread. The cost of the long call reduces the net credit you’ll receive and controls margin expansion.
This covered call synthetic bot workshop shows you how to add the strategy to your automated portfolio.
You can also see the automations in this covered call synthetic bot template.
Three market scenarios (and what to do)
Let’s look at an example:
Assume you own 100 shares of SPY and sell a 0.30 delta call option, 30 days until expiration, for $5.50. You purchase a 0.05 delta call option with the same expiration for $0.60 for a net credit of $4.90 (+$490 per contract).
Buying the call option reduces the initial margin by $3,500. So, for $60 less in premium received, you get more flexibility in your covered call position.
After you enter a synthetic covered call, there are three different scenarios you may encounter:
- The stock rises fast early in the expiration cycle
- The stock stays completely flat the entire time
- The stock falls fast
If the stock rises sharply early in the expiration cycle, you can sell the stock and hold the call spread for a potential reversal. You can also exit the call spread for a loss. However, you’ve already profited from the rising stock price.
If the stock is flat, no worries; you're making money on the spread while the stock is idle.
If the stock drops fast, you can close just the short strike and hold the long strike as a potential lottery ticket.
You can always sell the stock position and keep the short call spread. This allows you to hold the call spread if the stock continues lower or trades sideways.
If you are trading the naked short call option without the spread component, you now are faced with a larger margin requirement to hold the short call position.
Therefore, using a call spread is much more efficient from a capital and risk management perspective.
You can also trade around your short call spread, like converting it into an iron condor or iron butterfly to help cover the risk if the stock reverses up and starts to challenge the position after you've exited the stock.
There's a lot of flexibility here for a new trader, especially traders with smaller accounts, to use the spread instead of a single short call option.
Remember, we can’t control what happens after entering a position. We can control the entry, the selected strike prices, position sizing, tickers, management, and how to filter and enter positions. Take the time to think about the entire position and its timeframe before entering a trade, and it becomes much easier to manage the position as the market environment changes.
Learn more about covered calls with our free download: Mastering Covered Calls and follow along in podcast episode 172.