1. Covered Synthetics with Insurance
A Monthly Income Strategy Or
Covered Calls On Steroids

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 Goals 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 LEAPS Example
Recently IBM was trading at $130
Purchase a January 2011 $130 Call LEAPS for $9
Then Sell a January 2011 $130 Put LEAPS for $10
The result is a $130 Long Call and a $130 Short Put opening position.
There is $100 net gain because the sold Put brings in $1,000 and the Call cost only $900
This establishes an IBM Synthetic Long Stock Position
Note that Jan 2011 options are not really LEAPS because under 9 months these options are renamed

7. A Simple Comparison 100 Shares of IBM at $130 costs $13,000
One IBM Synthetic Long Stock position using January 2011 pays you $100 in cash!
And the two positions behave the same way!
Welcome to equivalency….where a complex option strategy (a long call and a short put at the same strike and expiration) is the same risk profile as simply owning a long stock position
One Synthetic Long Stock position controls 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
In this case $2,600 of BPE or ‘Initial Margin’ is equivalent to $13,000 to purchase the stock ($130 x 20% = $1,300)
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 LEAPS Put for $18. Total cost is $18,000 ($18 x 100 shares)
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 are happy because the entry cost is less….)

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
Example: $94.74/month ($1,800 / 19 months)
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. Covered Synthetic – The Broker’s Perspective

12. 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 and too low, so the decision was to go to the next month!)
Before the August Call expires, close and roll into a new front month Call

13. Next is Trade Management
Trade Management of a Covered Synthetic is complex
What front Month Calls should be sold? ATM, ITM or OTM
When should front Month Calls be closed and rolled? How many days before expiration?
When and how should the Synthetic Longer term Long Call and Short Put be closed and rolled?
What are the guidelines and firm rules?
Etc., etc., etc…

14. Here are Some Results
Five underlying equities were back tested for the last 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

15. Typical Results

16. Covered Call vs Synthetic Call
Symbol
ROI Cov Syn&Ins
ROI Cov Call
ROI Advantage
Capital Leverage
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

19. APPENDIX
For Further Discussion
and
Explanation

20. 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

21. More Issues
Is amortization of the Protective Long LEAPS 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?

22. 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 deep ITM + Short Call (front Month)
Covered Synthetic LEAPS = Long LEAPS Call + Short LEAPS Put (Same Strike)

23. 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

24. 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

25. 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