1. Covered Calls with Insurance Using Synthetics-YTD Results and Lessons Learned (November 6, 2010)

2. Disclaimer This presentation is for informational purposes only
Trading and investing always involve high levels of risk
Options have inherent special risks and are not suitable for every investor
Past performance shown in this presentation does not guarantee future results or success
You alone assume all responsibility for your own investment actions

3. Focus on Three Issues Improve returns on the Covered Call Strategy
2. Reduce the risk of Covered Calls because I want to sleep at night
3. Identify and improve what is needed to implement and manage this strategy

4. Covered Call Issues Typically a Low Rate of Return
Ties up a lot of Capital
Opportunity Lost on the Upside
No Downside Protection
Assignment Risk
If you don’t use this strategy for the long stock in your account, your broker will….

5. Overcoming Covered Calls Low Rate of Return
Most Covered Call Strategies Suggest Good Fundamental Stocks with Low Volatility
The Result is a Low Rate of Monthly Return (i.e., 1% to 3%)
Remedies include using ITM Strikes, using deep ITM LEAPS, selling Short Strangles
Or try using Synthetics

6. Covered Synthetic Example
Recently IBM was trading at $130
Purchase a January 2011 $130 Call for $9
Then Sell a January 2011 $130 Put for $10
The result is a $130 Long Call and a $130 Short Put opening position
This establishes an IBM Synthetic Long Stock Position

7. A Simple Comparison 100 Shares of IBM at $130 costs $13,000
One IBM Synthetic Long Stock position using January 2011 options pays you $100 in cash ! And the two positions are the same!
Welcome to equivalency….where a complex option strategy has the same risk profile as a simple covered call or buy /write strategy
One Synthetic Long Stock LEAPS position equals 100 shares of the underlying Stock

8. Can It Be That Simple? Yes and No…
Yes there is equivalence, but be careful because your broker has a say in this matter, depending upon your trading status
At this point the broker will require about a 20% Buying Power Effect (BPE) restriction for this Synthetic Long Stock position (cannot do in IRA)
In this case $2,600 of BPE is equivalent to $13,000 to purchase the stock
Now lets add a new element – I want to sleep at night………………………

9. Add Insurance So I Can Rest Easy
The next step in this strategy is to purchase an IBM January 2012 $130 Put for $18
This Put acts as insurance for the IBM Synthetic Long Stock position…and protects the whole position if IBM drops in price
And the $2,600 Buying Power Effect is replaced by $1,800 cost of the Put insurance (because an open short put is now balanced with a Long Calendar spread….and your broker is happy! And you can do this in an IRA….)

10. Consider the Put as Insurance
Now your broker looks at your position and notes that you have a Calendar spread, but you can look at this position from another perspective
Treat the cost of the Protective Put as prepaid insurance and allocate in monthly increments as protection to offset and mitigate the downside risk of the underlying because, as time passes, the extrinsic value of this Protective Put insurance will drop
Also note that the total cost of the Protective Put, however will not be offset and treat this as the cost of investing in this position.

11. Now Let’s Generate Monthly Income
Now that you have a Synthetic Long Stock position on IBM, sell front month call options for income
Sell an August $135 Call for $2.35 and bring in $235 of total premium…(note that the July call was only $.71 cents!)
Before the August Call expires, close and roll into a new front month Call

12. Next is Trade Management
Trade Management of a Covered Synthetic is complex
What front Month Calls should be sold?
When should front Month Calls be closed and rolled?
When and how should the Synthetic Long LEAPS be closed and rolled?
What are the guidelines and firm rules?
Etc., etc., etc…

13. Issues to Resolve
Need a Watch List of Stocks & ETFs with a neutral to mildly bullish bias…
How many? When is it best to rotate?
The screening criteria should include volatility and trade-ability
Need to establish better position roll and close guidelines
Need to establish clear entry / exit rules and criteria especially as it relates to theta

14. More Issues
Is amortization of the Protective Long Put reasonable for ROI & ROM?
Should strike selection of front month options be based upon volatility analysis?
Can the insurance pro-rating be coupled with dynamic hedging?
When is Breakeven for this strategy?
How does ITM / OTM and intrinsic / extrinsic option analysis affect the choice of the front month short call?

15. Covered Call vs Synthetic Call
Symbol
ROI Cov Syn&Ins
ROI Cov Call
Earnings Multiple
Capital Multiple
AAPL
175.5%
206.0%
0.9 times
4.5 times
XLE
37.5%
7.5%
5.0 times
7.1 times
IBM
96.5 %
22.7%
4.3 times
7.5 times
COST
65.2%
13.0%
6.3 times
XOM
18.5%
<4.9%>
4.8 times
7.6 times

16. What happens to position if stock moves up or down?

17. What to look for
Price of underlying > $50 (to minimize commission costs when rolling)
At least 10,000 contracts of open interest (for front month, synthetic month, insurance month if possible)
At least 100 volume at strikes used for all parts of position
$1 to $5 strike intervals (I like $1 and $2.50)
Betas from .75 to 1.75 (to contain the volatility)

18. Rules for Initiating Position
Initiate position at relatively low volatility to minimize insurance cost (i.e. wait until after earnings announcement; lower 1/3 of volatility range)
Stock in low end of Bollinger band or low end of RSI (desirable, but not necessary) This gives you a greater chance of stock moving up in the near term.
Sell front month call OTM (next strike up or preferably 2 strikes up if you can get decent premium)
Establish synthetic out at least 4 to 6 months (it takes a while for position to be profitable especially if underlying tanks out of the chute)

19. Rules for Initiating Position
Use LEAPS for insurance (to minimize theta decay; minimize monthly amortized cost; benefit from an increase in volatility)
Before initiating position check premium for past 6 months to evaluate profit potential (see next two slides)
NOTE: You may accept lower average monthly premium if stock is in steady uptrend (i.e. odds are greater that you will benefit from increase in synthetic)

20. Example #1: Past 6 months premium check

21. Example #2: Past 6 months premium check

22. Lessons Learned
Use LEAPS put at same strike as synthetic for insurance
LEAPS minimizes time decay and reduces monthly amortized cost
Same strike eliminates any buying power effect
Sell front month call OTM to give synthetic chance to work for you when stock is in an uptrend
Roll front month call if buyback exceeds 133% of premium received or absolute value of sum of deltas for front month call and insurance > 100 (you begin to lose money as underlying rises)

23. Lessons Learned
Roll front month call 7 to 10 days before expiration to take advantage of theta switch unless underlying is at the money (if at the money, you will be able to take advantage of greater theta decay)

24. Lessons Learned
Close out or roll synthetic position if delta on insurance LEAPS put < 35 or > 65 (i.e. the insurance isn’t protecting you or it is working against gains on synthetic)
Close out or roll synthetic position at least 60 days before insurance put expires (i.e. we want to keep as much of the unused insurance premium as possible).
Close out or roll synthetic position if front month call strike is substantially below the synthetic strike and creates buying power effect (margin requirement)
E.g. front month call strike is 50 and synthetic strike is at 60—this ties up $10 of margin

25. Why OTM Front Month Calls vs ATM?
We expect the underlying to rise so we want to benefit from rise in synthetic long stock position up to the front month strike

26. Why OTM Front Month Calls?
Example when ATM front month call is used:
At initiation of position:
Synthetic= delta
Insurance= delta
Front month call= - 50 delta (ATM)
If stock moves up:
loss on front month call and insurance equals gain on synthetic (synthetic = +100 delta and sum of insurance and front month call = -100 delta)
RESULT: NO GAIN ON POSITION

27. IMPORTANT!!!
BE SURE TO SET CONDITIONAL ORDER TO BUY BACK FRONT MONTH CALLS PRIOR TO EXPIRATION OR IN-THE-MONEY OPTIONS WILL RESULT IN A SHORT POSITION IN THE STOCK ON MONDAY MORNING

28. How I track positions (Part 1)

29. How I track positions (Part 2)

30. Year to Date Returns

31. Year to Date Returns (cont.)

32. Additional Slides from Harold’s June Presentation Follow

33. APPENDIX
For Further Discussion
and
Explanation

34. Covered Synthetic – The Broker’s Perspective

35. Here are Some Results
Five underlying equities were back tested back two years
Detailed guidelines and rules were established and applied. The process is ongoing and has been evolving
Several of us have already put on positions and the results are encouraging

36. Typical Results

39. Covered Call Equations
Covered Call = Long Stock + Short Call
(short call strike ITM or slightly OTM)
Covered Strangle = Long Stock + Short Call OTM and Short Put OTM
Covered LEAPS = Long LEAPS d. ITM + Short Call (front Month)
Covered Synthetic LEAPS = Long LEAPS Call + Short LEAPS Put (Same Strike)

40. A Quick Synthetic Primer
Equivalency - the purpose is to break down complex option positions into simpler strategies for the purpose of defining risk.
The Synthetic Triangle relates Stock, Puts and Calls
A combination of two elements in the synthetic triangle creates a synthetic position of the 3rd element.
The synthetic triangle is governed by the principle of Put / Call Parity
Synthetic Long Stock = Long Call + Short Put

41. A Basic Covered LEAPS with Insurance
Insurance for a Covered Call Position is to purchase a Protective Put (aka a married Put)
The Synthetic LEAPS will be to purchase a Long LEAPS Call and a Short LEAPS Put same strike, same month At-The-Money
Then purchase a Long LEAPS Put either the same as above or a farther out LEAPS option chain

42. What is The Equivalent and Why Does It Matter
The equivalent is that you have set up a Calendar / Horizontal Put Spread, if both Puts are same strike and
There is also a Calendar / Horizontal Call spread if the short front month call sold and the long LEAPS call are the same strike
More often the Call Spread will be a Diagonal
Since both positions are Long there will not be any Buying Power Effect