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Chapter 5. Two Popular Strategies and Ho... > Chapter 5 Major Learning Points

Chapter 5 Major Learning Points

In this chapter we’ve learned about Synthetic Calls and Covered Calls. Let’s compare the two strategies:

 Synthetic CallCovered Call
Strategy

OutlookBullish, although you are insuring your stock purchase.Mildly bullish. You expect a steady rise.
Rationale
  • To buy a stock for the medium or long term with the aim of underwriting your downside in the meantime.

  • If the stock price rises more than the cost of the bought put option, you will make profit.

  • If the stock falls, you will lose money, but your losses will be capped at the level of the put strike price.

  • To buy a stock for the medium or long term with the aim of capturing monthly income by selling calls every month. This is like collecting rent for holding the stock and will have the effect of lowering your cost basis of holding the stock.

  • If the stock rises, you short call may be exercised, in which case you will make some profit. If the stock falls, your sold call will expire worthless, you will keep the premium, thus enabling you to have bought the stock cheaper (because you offset the received premium against the price you paid for the stock).

Net position
  • This is net debit transaction.

  • Your risk is limited if the stock falls.

  • This is a net debit transaction because you are paying for the stock and only taking in a small premium for the sold call options. You can increase your yield by purchasing the stock on margin, thereby doubling your yield if you use 50% margin.

  • Your risk is the price you paid for the stock less the premium you received for the call.

Effect of time decay
  • Time decay is harmful to the value of the put you bought.

  • Time decay is helpful to your trade here because it should erode the value of the call you sold. Provided that the stock does not reach the strike price at expiration, you will simply retain the entire option premium for the trade, thus reducing your original cost of buying the share. If the stock price does reach the strike price of the call, then you will either be exercised early, in which case you’ll sell the stock at the higher price (that is, the strike price), or you’ll be exercised at expiration, where the same thing will happen.

Safest time period to trade
  • Buy the puts with expirations with at least half the period you want to invest in the stock.

  • Sell the calls on a monthly expiration basis.



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