More Than One Way to Skin a Cat
04/08/2013 8:00 am EST
Whenever you want to stake a position, but are constrained from creating it by capital costs or an existing position, you should consider its synthetic equivalents, counsels Russ Allen of Online Trading Academy.
In last week’s article, I wrote about creating an option position out of different ingredients. We started with a stock position, and then added a protective put for insurance. This combination is called a married put.
Next we demonstrated that a simple call option had the same profit or loss potential as that married put. At any price of the underlying on option expiration day, the profit or loss for the two positions was the same. But a big difference was that the call option cost $6 per share, while the married put cost $104. So we could say that a married put position is just a more expensive synthetic equivalent of a long callat the same strike.
Now let’s take a look at another popular option position—the covered call—and its synthetic equivalents.
The Covered Call
The covered call is one of the most popular of all option strategies, and for good reason. It’s simple to understand and easy to do. It can be done in any type of brokerage account, including IRA accounts. It gives longer-term investors a way to increase the returns from their stock positions, in exchange for reducing the upside profit potential. It is considered a “safe” and conservative strategy.
This time we’ll use a real-life example. At the close on March 27, the stock of Wabtec Corp. (WAB) was at $99.81. The May $100 calls were at $2.93, and the May $100 puts were at $3.08. (All prices shown are the midpoint between the bid and ask prices). Let’s look at a covered call, and then we’ll create a synthetic equivalent.
In our Wabtec example, we could sell the May calls for $2.93. Subtracting that from our cost of $99.81, our new effective cost becomes $96.88. That amount is therefore our new break-even price, as well as our maximum loss. We will now have a profit on the net position as long as WAB remains above $96.88 at expiration, or a loss if WAB is below that price. If WAB is above $100 at expiration, the stock will be called away from us, and we’ll be paid $100 per share. We’d then make our maximum profit of ($100 – $99.81 = $.19) on the stock, plus $2.93 on the call, for a total of $3.12. This would be the most we could make, no matter how high the price of WAB goes.
With the covered call position, we now have two risks. The first is the same one that any owner of WAB has—that its price may drop. But although a drop in the price of our stock still hurts us, we’re better off in any down scenario than if we had not sold the call. We have the $2.93 that we received for the call. The price of WAB has to drop now not just by a penny, but by $2.93 for us to begin to lose money.
NEXT PAGE: The Synthetic Equivalent|pagebreak|
The new risk that we’ve taken on by selling the call is an opportunity risk. Because we are now obligated to sell the stock at $100, we will forfeit any profits on the stock itself should it go beyond $100. The opportunity for unlimited profit is gone, given up in exchange for the call premium.
So we now have a position with a limited profit. It will pay better than the stock alone in any case except where the stock rises by more than $3.12 from its current level. If we are neutral to slightly bullish on the stock, and think it’s not likely to rise by more than $3.12 in the next few weeks, this might be a good trade.
The cost to enter the trade in a cash (non-margin) account, such as an IRA, would be $99.81 for the stock, less $2.93 received for selling the call, or a net of $96.88 per share.
In a margin account, we could enter the trade for 50% of the cost of the stock, or $49.91, less the $2.93 option premium, for a net of $46.98 per share. We would pay interest on the borrowed half of the stock cost ($49.91).
Other Ways to Skin the Cat—the Synthetic Equivalent
Now, let’s look at a synthetic equivalent for the covered call position. Remember from last time the basic synthetic equation is:
Long stock + long put = long call. The profit/loss from owning a stock and a protective put, is exactly the same as the P/L from owning a long call with the same strike as that put.
Using S for stock, C for call, P for put, and using plus signs for long positions and minus signs for short positions, we can write that basic synthetic relationship as an equation:
+S + P = +C
Our current position is a covered call, which is long stock with a short call, or
+S - C. Let’s see what its synthetic equivalent is. We want to rearrange the synthetic equation so that +S - C is on one side of the equals sign, and see what is on the other side.
Starting with the basic synthetic equation of +S + P = +C, we need to get our covered call, which is +S - C onto one side of the equals sign. subtracting P from both sides of the synthetic equation:
+S + P = +C
+S +P -P = +C -P, or
+S = +C - P
Now subtracting C from both sides:
+S - C = +C - C - P, or
+S – C = - P
So the synthetic equivalent of out covered call [+S - C] is a short put [-P].
The Short Put
For our WAB example, If instead of the covered call, we don’t buy or own any stock, and just sell a $100 put short, our profit or loss should be the same. Let’s see.
We could sell the $100 put for $3.08. If WAB goes up by $.19 and then stays above $100 after expiration, we get to keep the whole $3.08. That is our maximum profit on the short put. This is virtually the same as the $3.12 maximum profit on the covered call, and at the same price ($100 or higher).
NEXT PAGE: P/L Diagrams for Two Positions|pagebreak|
If WAB stays below $100, the WAB stock will be put to us (i.e. we will be forced to buy it) upon expiration. Our cost will be the $100 that we’ll be forced to pay, less the $3.08 we already received for selling the put. Our net cost will be $96.92. This is within pennies of our $96.88 net cost for the covered call. At expiration, we’ll have a profit if WAB’s price is above that cost, and a loss if it’s below. Same situation as the covered call.
The capital cost for the short put position depends on whether we have a cash account (like an IRA) or a margin account. In a cash account, selling the $100 put requires that we have $100 in cash. This is so that if we are forced to buy the WAB stock for $100, the money will be there. Our obligation to buy the stock is secured by the cash in the account. This method is called selling a cash-secured put. Deducting the $3.08 that we’re receiving from the put, this trade would require $100 - $3.08 = $96.92 of our own money. This is virtually the same as the covered call capital requirement of $96.88.
If we have a margin account, and if the broker grants the approval for us to do so, then we can enter the short put trade with less capital, usually about 20% of the strike price (brokers set their own rules for the exact amount). If we have a margin account and approval from the broker, we would be able to enter this trade for around $20. This is considerably less than the capital required to do the covered call trade in a margin account, which was $46.98. Also, in the case of the covered put, there is no margin interest charged. Our $20 margin requirement is a deposit, not a partial payment. Selling puts in this manner is called selling naked puts. It requires a higher level of authorization, because of the possibility of receiving margin calls—demands for additional cash to be deposited into the account. This can happen if WAB drops such that the original $20 is no longer an adequate cushion. If we already had the whole $100 security in the account, of course, there could be no margin calls.
P/L Graphs for the Two Equivalent Positions
Below are the P/L diagrams for the covered call and the short put. Notice that they are indistinguishable. That’s why they are called synthetic equivalents. We can get exactly the same results in more than one way.
Covered Call and Short Put P/L Diagrams
So whenever we have a desired position, but are constrained by capital costs, an existing position, or other factors from creating it, it’s worthwhile to consider that position’s synthetic equivalents. We may very well find another way to skin the cat.
By Russ Allen, Instructor, Online Trading Academy