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The Sell Put And Buy Call Strategy is an example of a synthetic stock options strategy: using call and puts options to mimic the performance of a position, usually involving the purchase of a stock.

We saw this when looking at the synthetic covered call strategy elsewhere.

In this case, what is being mimicked is a long position on a stock by selling a put and buying a call at the same strike price and expiry (usually at the money). Here’s how it works in more detail:

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Long Stock

A Long Stock, purchased at $50 has the following payoff diagram:

As you would expect if the stock rises above $50 the ‘position’ is profitable and gets more profitable as the stock rises further. And the converse is true too: below $50 the stock is unprofitable and gets worse as the stock price falls.

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How To Place A Synthetic Long Call

In order to place a synthetic call, it’s important to remember one of the key principles of options trading: if the pay-off diagrams of two positions are the same then they are, in effect, the same trade.

Therefore all we need to do is construct an options spread that has the same pay-off (or ‘P&L’) diagram as the above and we have ‘synthetically’ created a long call.

And the spread that does the job is to buy an at the money call and sell an at the money put. Both should have the same expiry date.

The long call has the following P&L diagram:

And here’s the short put’s pay-off:

And when put together they produce:

Which is, of course, the same pay-off diagram as the Long Stock above, and therefore the same trade.

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Advantages Of The ‘Sell Put And Buy Call’ Strategy

Why would you go to the bother of putting on the synthetic version of a bought stock when you could quite easily just buy the stock? Here are a couple of reasons:

Lower Capital Outlay

To own stock you require the capital to purchase the shares. Even if you’re buying stock on margin you still need to deposit 50% of the purchase price with your broker.

The margin requirements for the ‘sell put and buy call’ strategy is much smaller and therefore less cash is required.

Flexibility

Because options are involved a sophisticated trader has more, well, options to manage the trade.

For example if the stock price drops, therefore increasing the price of the short put, it could be rolled down (ie sold at a lower price point) or out (buying back the put and selling a put of a later expiry date).

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Downsides To The ‘Sell Put And Buy Call’ Strategy

With all options trades there is a downside to consider to placing the synthetic version of the long call. Here are a few:

Dynamic Margin

The required margin is lower than a purchased stock as we’ve seen. However, because the trade includes an uncovered sold put, your broker will recalculate your margin requirements daily. If the stock has moved down significantly you’ll be asked to post more margin immediately.

Increased Leverage

For a smaller amount of capital you’re being exposed to the full risk profile of the stock. Therefore, when compared to the capital outlay you have more risk.

This is the flip side of being able to put the trade on for less capital: you’ve effectively leveraged yourself to the stock price. You could get more return (on your capital requirement) but for a greater risk.

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Conclusion

The ‘Sell Put And Buy Call’ strategy, the sell of an ATM put coupled with the purchase on an ATM call, is a way of creating a synthetic long stock position. It requires a lower capital outlay than simply purchasing the stock, but also exposes you to the same risk.

We’ve looked at both these options spreads before – but which one is better? Here’s the bull call spread vs bull put spread head to head…

Both the bull call spread and bull put spread produce a limited profit with limited risk on a rise in the price of the underlying security. However the former is a debit spread which decreases value over time and on an decrease in implied volatility; the latter is a credit increases in value over time and on a decrease in volatility.

First let’s look at what each these vertical spread strategies entails:

Bull Call Spread

A bull call spread involves the purchase of a (usually out of the money) call option, partly financed by the sale of a call with a higher strike price but the same expiration date. It is a debit spread (it involves a cash outlay).

Here’s the P&L diagram:

A trader would put this spread on if they believed that the stock would rise, but was unwilling to risk losing all their call premium investment should the trade go against them. Thus they are willing to give up some of the upside to protect the trade.

Another way of looking at this is with reference to the options greeks.

Delta

A call option is strongly delta positive (ie it is sensitive to stock price movements). The sale of the call option, making a bull call spread, reduces the delta of the trade, and hence minimises the loss should it go against the investor.

Vega

A more subtle risk is vega, the sensitivity to changes in volatility. A call option is vega positive; it rises in value with a rise in implied volatility (and vice versa).

Unfortunately volatility tends to fall as stock prices rise, reducing the gains to a long call should the stock rise. Again the sold option reduces the position’s vega, reducing this effect.

Theta

Again a long call has negative theta – it falls in value over time – but this is mitigated by the sale of the call to make a bull call spread.

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Bull Put Spread

A bull put spread involves the sale of a (usually out of the money) put option combined with the purchase of a further out of the money put. It is a credit spread – a net premium is received.

Here’s the P&L Diagram:

As with the bull call spread the trader believes the stock will rise hence he/she will get to keep the premium earned.

Some of the greeks, however, are different:

Delta

This is the same as before: the spread is delta positive but less so than the outright purchase of the put.

Vega

The spread is now vega negative: as volatility rises the options’ values fall which, given the trader has sold them for a net credt, this is good news.

Therefore as the stock rises, and volatility falls, the spread falls in value (again, good news). This increases the spread’s profitability (but also the risk – if the stock were to fall, volatility would rise and the options rise in value).

Theta

Unlike before, theta works in the trader’s favor: the bull put spread is theta positive. As time passes the spread increases in profitability.

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Bull Call Spread Vs Bull Put Spread

Here then are the similarities and differences of these two options strategies:

Similarities:

• Both spreads have similar P&L Diagrams: they make a limited profit/loss if the stock price rises/falls.
• Both are delta positive: they are put on should a trader expect a stock to rise.
• Both a limited risk strategies: their downside is limited (at a cost of a limited upside)

Differences:

• The bull call spread is a debit spread, whereas the bull put spread is put of for a net credit
• The bull call is vega positive: it increases in value with increases in volatility. Whereas volatility increases reduces the value of a bull put spread.
• The bull call theta negative: it loses value over time; the bull put spread increases in value over time.

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So Which Is Better?

As with most options related question, the answer is ‘it depends’.

Some options traders are happier with the relatively easy to understand debit spread; others love to see the value of the their credit spreads increase over time.

Whichever one you chose, be careful to understand risks – especially the more subtle options greek risks – beforehand.

Is Options Trading Wise In Retirement? Or are options not suited to retirement investing? And if options are suitable, what option trading strategies are best for retired investors? Which options spreads should be avoided by retirees? We investigate…

Options trading is perfect for retirement investing, if the right strategies, such as the protective put and the covered call, are used. However many other riskier strategies such as selling uncovered options, and complex options spreads such as the calendar spread, are less suitable as potential losses can be large and are complicated to manage.

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Is Options Trading Wise In Retirement?

To answer that question, let’s first consider the most suitable investment types for seniors and older investors in retirement.

Risk Averse

Most financial advisors would say that an investor’s appetite for risk should decrease over time.

Younger investors can take on more risk, and potentially earn a greater return, as they have smaller balances to preserve and have more time to recoup losses over time.

As they get older, however, they will (hopefully) have a larger amount wealth to preserve and less time to ride out the ups and downs of risky investments.

Simplicity

It is unlikely that retirees would wish to invest in anything complicated or requiring significant additional learning. Hence, unless they had experience in an area the simpler the better.

(This is, of course, an over generalisation. Retirees have more time on their hands and might love to learn a new skill, such as learning how to trade options).

And so, does options trading pass these tests?

Well, thankfully options are one of the most versatile investing vehicles and there are several options trading strategies that meet these criteria.

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Best Options Trading Strategies For Retirees

Protective (Or Married) Puts

A protective put involves buying a put option – giving the holder the right to sell the underlying stock – to protect an existing shareholding.

(A married or covered put is when the shares being protected are purchased at the same time, rather being already held. The following applies for these covered puts too).

So if a retiree has a portfolio of shares (or is buying one in the married put case) they can ‘insure’ against losses.

For example consider a retiree who could withstand a significant fall in their investments (20% say) without a change in lifestyle, but is concerned a larger stockmarket crash could affect their future quality of life.

The purchase of out of the money put options with an exercise price 20% below the market price could insure against this risk, at a reasonably low cost.

This is risk averse – it actually reduces risk – and is simple to implement. It does, however, come at a cost, albeit a small one.

Covered Calls

One of the simplest and most common options strategies is selling call options against existing stock positions.

This is slightly riskier than the above strategy as it shares could be ‘called away’ if they rise above the call option’s strike price.

However this can be mitigated by setting this exercise price at a significant premium.

For example suppose an investor holds 100 IBM shares currently trading at $100/share. The could sell a 3 month 110 call option, receiving a premium of, say, $5/share (or $500 in total).

Then, either IBM finishes below $110 in 3 months time, whereby the investor keeps the $500. Or it rises above $110, whereby the investor keeps the $500 plus sells their 100 shares at a 10% premium to the starting market price.

Zero Cost Collar

The above two strategies could be combined into a costless collar.

This is more complex – threatening to break one of our two criteria – but is a lovely way for a more sophisticated retiree to reduce the risk of a major fall in their share portfolio at no cost.

The strategy involves buying an out of the money protective put against their share portfolio, financed by the sale of an out of the money covered call.

The required insurance is obtained at no cost, with the only risk being missing out on a substantial share price rise (ie one over and above the call option’s strike price).

Options Strategies To Avoid

The options spreads to avoid are, as you’d expect, those that fail the two tests above. Namely, they are either risky, complex or both.

Uncovered Sold Positions

Writing call and puts without owning shares (calls) or having the cash to cover the position (puts) is very risky. In theory these positions could lose an infinite amount of cash. Avoid.

Credit Spreads

Less risky than uncovered options sales, credit spreads such as the bear put spread and bull call spread are still too risky.

Backspread Or Other Complicated Strategies

Backspreads and other complex trades are too complicated for our needs.

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Conclusion

In conclusion then, options can form an valuable part of any retiree’s investment portfolio – but only if the right strategy is selected.