May 15, 2003

The Synthetic Covered Call
by John Brasher, Publisher

You may have heard reference to a "synthetic" covered call and wondered, is there such a thing? You bet, it's known as a short put - in other words, a naked put. A "synthetic" position is one that has the same profit and loss characteristics (meaning it profits and loses the same) - at expiration - as an unrelated position constructed out of completely different instruments.

Win two ways...

Since a covered call and naked put win and lose the same, each is the synthetic equivalent of the other. So if you want to write naked puts in an IRA account (not allowed), you would have to do it in the form of writing covered calls. Why are the covered call and short put equivalent to each other? Easy, they both profit if the stock price stays the same or rises, and both lose if the price drops.

Example: Assume that when DELL is $25, the 25 Put can be sold for $1.00 and the 25 Call for $1.20. Let's examine the dynamics of each possibility at option expiration:

Possible Results at Expiration:

Stock price remains stable:  If the stock finishes at $25 at expiration, both positions won. The covered call writer pocketed the $1.20 premium, an easy 4.8% return for a few weeks' hold. Meantime, his stock still is worth $25, so he can either sell the stock to close the position and get his principal back, or write another call. The naked put writer is golden, also, since the $1.00 put was 100% profit: 4% for a few weeks' trade risk.

Stock closes up:  If the stock closes higher than $25 at expiration, the covered call writer will be called out of the DELL. He paid $25 for it and if called must sell it for $25, so there is no extra profit from being called. (You only make more from being called out when you wrote an out of the money call.) The naked put writer's return does not increase, either, because his greatest potential return - the put premium - has already been pocketed. The covered call looks like a much better play, doesn't it? But remember: (1) the naked put writer does not have to tie his capital up buying the stock at $25 per share, and (2) the call writer makes the extra return upon being called out only when he wrote an out-of-the-money call.

Here's how expiration looks if the stock closes at or above $25:

Stock closes down:   If the stock moves down, different story. Assume the stock closes at $22. The call writer's $1.20 premium protected him against a drop down to $23.80. He can either sell the stock and take a $1.80 loss ($23.80 - $22), or if he is comfortable with the stock, write another call to further lower his basis in the stock. The put writer also takes a loss. He got $1.00 for the put, but since the stock's drop slid the 25 Put in the money at expiration, the stock was put to him (he was obligated by the put option to buy it). His loss will be $2.00, because he has to buy the stock at $25, resells it for $22, but got $1.00 for writing the put. [(25 - (22 + 1)]. Here's how expiration looks if the stock closes at $22:

Risk:  Another way of analyzing the covered call and naked put positions is to say that the covered call writer's premium protected him down to $23.80, and the put writer's premium protected him down to $24.

If you are bullish on a stock after doing your "technimental" analysis (we look at technicals and fundamentals, as well as news), then the covered call or naked put is a great choice. The naked put ties up less capital, of course, but fewer people can write a naked call or put, since your brokerage account must be approved for Level 3 options trading in order to write naked options. Your options approval level will depend primarily on your broker's policies (some don't allow naked writing by anyone), your account size, history with that broker and options trading experience. If you are new to options trading and have a small account, you won't be allowed to write naked.

CallWriter's Real Time Lists™ are the absolute best place to find great covered call and naked put plays, since they always show you the fattest premiums. And they're automatically updated all through the trading day.

The Deep Out of the Money list is just what you've been waiting for! Now we find the fat returns for you that are comfortably out of the money. Writing naked calls that are at or close to the money is nerve-wracking and dangerous. Now you have the ideal lists. You can write a naked call and, if the stock moves up on you, cover by purchasing the stock when it crosses the call's strike price. Knock 'em dead!

Want to write naked puts but your broker won't let you? CallWriter has a strategy that allows you to write (nearly) naked puts. We'll be telling you all about it soon. It's a "credit" strategy that puts money in your jeans, meaning you get paid to run the trade! See the article on "Bearfoot Calls". And tell your friends to sign up for the MONEY newsLETTER so they can learn the secret, too!

Good luck and good trading!