This segment covers the best way a trader can create a covered call, how to do so synthetically and why to do so.
Tom Sosnoff and Tony Battista begin by explaining what a covered call is; it’s a position of being long the underlying and short calls that if exercised against the trader would completely cover the position and leave him flat.
Examples of both a covered call and a synthetic covered call using Facebook were displayed. A table displayed the max profit, buying power reduction with margin (BPR), downside protection, probability of profit (POP) and max return on capital (ROC) on both strategies.
What are some of the reasons for establishing a covered call? A trader who already is long the underlying can sell calls against shares of his stock and it provides protection against down moves, increases probability of profit to over 50% and reduces the cost basis of the trader’s stock.
The optimal volatility environment for entering a covered call is when Implied volatility (IV) and IV Rank are high. That’s because we are selling premium.
We can also construct a covered call synthetically. It’s a more capital efficient way to construct a covered call and we do so by trading a diagonal. The trader purchases an in-the-money (ITM) LEAP call (180+ DTE) and selling a shorter-term call against it every month. The example using Facebook was shown earlier in the segment. By using an ITM call with a long time to expiration in substitution of long stock we have almost the delta as the stock, minimal time decay and a much lower hit to buying power. It also reduces our overall risk and increases are return on capital.
There are some potential drawbacks to using the synthetic strategy. The deltas are not going to be as much, there is some time decay at the beginning and at 45 DTE it really starts and the liquidity in the calls, especially initially when they are LEAPS, is going to be much thinner.
Watch this segment of Best Practices with Tom Sosnoff and Tony Battista for a valuable discussion about covered calls and their variations.
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