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Covered Call vs. Synthetic Covered Call

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In our quest to understand trading options for income, we often consider the popular Covered Call strategy. The Covered Call is a conservative strategy which requires buying 100 shares of stock (the underlying equity), and then selling 1 Call option (against the underlying). The sale of the Call option reduces the cost basis of the stock, improving ROC (return on capital) while limiting profits.

However, there is a more efficient approach to this strategy called the Synthetic Covered Call. By dramatically reducing the cost of capital, we improve the ROC while reducing risk. The Synthetic Covered Call is a combination of synthetic stock and the sale of the Call option. Synthetic stock is comprised of a long deep ITM (in the money) Call and a short Put, at the same strike within the same option chain. The risk profile of synthetic stock is similar to the risk profile of long stock.

To determine the advantage of the Synthetic Covered Call, Tasty Trade recently conducted a test of four stocks: MOS (Mosaic Co.); X (US Steel); MRVL (Marvell Technology Group); HPQ (Hewlett Packard Co.). For Synthetic Stock, options with a DTE (days till expiration) of around 9 months were selected at approximately 85 delta (for a risk profile comparable to the underlying stock). The short call selected was one strike OTM (out of the money) with a DTE of around 2 months.

The results: a considerable reduction in capital at risk was obtained in all cases: less than 25 percent of the cost for a standard covered call (except MRVL at 65 percent).

In conclusion, even in low IV environments the Synthetic Covered Call offers considerable reduction in capital at risk; thereby improving ROC. This approach should be considered if you do not wish to hold the stock indefinitely (9 months per this test).

If you would like to learn more about options, and how to generate consistent weekly income trading options, go to Options Annex.

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