How To Use Synthetic Calls And Covered Calls In Trading

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Options trading is a potentially lucrative way for traders to make a profit. However, many traders shy away from this product because of the perceived complication that comes with trading options. Indeed, for beginners trading, it can be overwhelming just learning about how an options contract works. However, if you have been in the game for a while and you are ready to level up, you may want to spend some time studying new ways you can trade and expanding your repertoire.

In this article, we will examine two popular options trading strategies: synthetic calls and covered calls. We will first explain what they are, giving comparisons to more traditional and basic options trading strategies so there is some common ground. We will then discuss how you can use each strategy, and the pros and cons that come with them. If you are eager to expand your library of trading strategies, read on to learn more.

What are synthetic calls?

A synthetic call is an options strategy where a trader combines a long position in the underlying and another long position at-the-money (ATM). The main goal of the synthetic call is to protect the position and minimise risks when trading stocks. Some traders may refer to this strategy as a protective put.

What are covered calls?

A covered call is a similar options strategy where a trader combines a long position in the underlying and a short position out-of-the-money (OTM). The main goal of the covered call is also to protect the position and minimize risks when trading stocks. Some traders may refer to this strategy as a buy-write strategy.

When to use each method

Now that you have an idea of what the options strategies are, you may be wondering when you can use them.

When to use synthetic calls

A synesthetic call is a bullish strategy, but it is not a profit-making strategy. Rather, traders use it when they are uncertain about how an instrument will perform and they want a safety net to fall back on. Generally, in this scenario, the trader feels that the general direction of the market is bullish but has no other certain predictions after that.

Traders also use the synthetic call when they have an existing position they do not want to close, but they want to protect themselves against volatility and limit their potential for losses.

When to use covered calls

A covered call is a mildly bullish strategy. Traders can also use it when they feel neutral about market developments. The main point is that the trader must feel that there is some sort of stability in the market that will stick around for a while.

Unlike the synthetic call, the covered call is a much riskier strategy as it offers limited profit but unlimited losses. Therefore, traders only use it when they are certain that the market will not be bearish in the future.

How to trade with each method

If you understand what each method does and you are ready to apply them to your trading, you can begin by following some steps for each one.

How to trade a synthetic call

To trade a synthetic call, you should first buy a stock in the traditional sense and physically own it. You should then buy put options with a strike price that is close to the price at which you bought the stocks earlier. Of course, the lower the breakeven point, the better your chances are of making a profit. However, you will increase your risk by a bit with this.

How to trade a covered call

To trade a covered call, you should first buy a stock in the traditional sense and physically own it. If you are planning to hold them in the medium term, you should then sell call options simultaneously. Ideally, you should sell these call options OTM – in other words, at a higher strike price than the price at which you bought the stocks earlier.

One thing that differentiates covered calls from synthetic calls is that you sell options in a covered call. This is a riskier endeavour, because you create an unlimited risk profile. Therefore, you should make sure your options have a short-term expiration date. However, do note that short-term options will naturally be more expensive daily.

Advantages of using the synthetic call

There are several advantages of using the synthetic call as a risk management strategy. Below, we will outline them:

  • The synthetic call is one of the lowest-risk strategies out there, and beginner traders can use them without much advanced knowledge. This is because a synthetic call caps the trader’s downside risk, immediately limiting losses, while profits remain unlimited.
  • There is an unlimited profit potential with the use of a synthetic call, and losses are capped.
  • The trader holds an existing position in the stock market. This means they may be eligible for dividends and the right to vote, depending on the stock they hold.

Advantages of using the covered call

Like the synthetic call, there are advantages of using a covered call. Below, we will outline them:

  • The ability to generate profit from relatively stable markets with little fluctuation is one of the greatest advantages of using the covered call.
  • This strategy can also be used on any stock, offering traders a chance to diversify their portfolios easily.
  • Like a synthetic call, the trader holds an existing position in the stock market. This means they may be eligible for dividends and the right to vote, depending on the stock they hold.

Considerations when trading options

Regardless of the options trading strategy you use, there are a few considerations you should factor in before you spend your real money. They include:

Your risk appetite

Knowing the level of risk that you are willing to take on or that you are comfortable with is the starting point for trading options. Options themselves can be quite complex, so you should do your homework before going into different trading strategies. If you are someone who cannot stomach high risks, you should stick to using the synthetic call. If you are a bit more open to risk, you can buy a slow-moving stock and use a covered call to potentially generate a profit.

Stock behavior and market performance

You should also consider the overall market conditions when using these options strategies. Spotting the general direction of the market is a must, and you may apply technical analysis to identify when patterns start and end. This can give you a great boost into gauging the kind of strategy you will need to use.

The bottom line

Options trading can be complex, and they can become even more so when traders attempt to use slightly more complicated strategies. However, if you are looking for ways to limit your losses and increase your risk management skills, a synthetic call is a great place to start. And if you are looking for ways to potentially profit from stable markets, a covered call is the answer. Depending on the company whose stocks you choose to trade, you may even receive dividends as you execute these strategies. Regardless, it is important to remember that all forms of trading include risk, and you can very well lose your premium if your predictions go off-course.