Sunday, March 16, 2008

More on the DIA/DXD Hedged Covered Call

This blog is mainly about covered calls. Other option strategies and synthetic relationships aren't normally discussed here. However, I felt that I needed to explain the true nature of the DIA/DXD hedged covered call strategy I posted earlier so that you can fully understand the risks involved.

Selling covered calls on the DIA/DXD pair is synthetically equivalent to a short strangle on DIA and therefore has the same risk profile.

Let's break this down. First of all, you should know that a covered call is synthetically equivalent to selling a naked or cash secured put. So, this trade, in it's simplest form, is the sale of two naked puts, one on DIA and one on DXD. However, DXD is the equivalent of a short position on DIA, so the naked put on DXD is actually equivalent to a naked call on DIA. So, what we now have is a naked call on DIA and a naked put on DIA, or a short strangle. The maximum profit zone is between the strikes, and the risk is above the strike of the call and below the strike of the put, plus/minus the option premium received.

The DIA/DXD double covered call in my previous paper trade example, which I sold at 5% OTM on DIA and 10% OTM on DXD, is equivalent to a short strangle on DIA that's +/-5% OTM. For example, short the DIA 127 call at $1.16 and short the DIA 115 put at $1.44. The risk is therefore, above 129.60 (127.00+1.16+1.44) and below 112.40 (115.00-1.16-1.44). This trade only profits if DIA stays within this range, and the maximum profit of $260 is achieved if DIA stays between 115 and 127. A loss will occur if DIA rises above 129.60 or falls below 112.40. A picture is worth a thousand words, so here's a risk graph:

Now you can't trade a short strangle in an IRA account, since you need margin in order to sell the naked call part of the position. So, selling covered calls, or naked puts, on the DIA/DXD pair is the only way that I know of to trade a short strangle on DIA in an IRA account. I chose to sell far OTM calls in order to increase the profit zone (i.e. the range of prices DIA can move) and still maintain an annualized cash return of 12% or more. This also reduces the risk of assignment and should require less adjustments. The closer to the money you sell the calls, the smaller the profit zone and the larger the risk/reward and potential for adjustments.

So, although this might look like easy money, since you have a hedged stock position, there are risks involved. Understanding this risk is important, and hopefully this article has provided you with that understanding.