A Synthetic Covered Call Strategy
CME: E-Mini S&P 500 Options ( 
ES1!), E-Mini Nasdaq 100 Options ( 
NQ1!)
Last Friday, the S&P 500 closed at 5,277.5, up 10.6% year-to-date. The Nasdaq Composite settled at 16,735.0, advancing 11.5% YTD.
This year, the chances of aggressive interest rate cuts diminished rapidly amid solid employment data and cooling US inflation. However, these headwinds could not stop US stocks from reaching one new record after another.
Over the past year, the Fed’s official rhetoric has shifted from hawkish to dovish, and then back to hawkish again. But action speaks louder than words. Since the last rate hike in July 2023, the Fed has kept the interest rates unchanged in the last six FOMC meetings.
According to CME Group’s FedWatch Tool, the probability of a no-rate-change decision in the June 12th FOMC is 99.7%. There is an 81.2% chance that the Fed Funds rates stay at 5.25%-5.50% on July 31st. The futures market expects the first 25bp rate cut on September 18th, with a 64% probability (Data as of June 4th).
(Link: cmegroup.com/markets/interest-rates/cme-fedwatch-tool.html)
Fed’s monetary policy has been the dominant driver of global financial market conditions in the last two years. The absence of Fed actions helped reduce market volatility. As a result, the VIX index plummeted from 19.2 on April 15th to 12.9 on May 31st.
Exploring Covered Call Options Strategies
Low volatility suggests that the US stock market is likely to move sideways in the near future. If you own stocks, you may finish the year with a positive return, as the two major indexes have already yielded 10-11% YTD.
If you plan to enter the market now, buying stocks is quite challenging. I personally have a hard time justifying a lofty price while the expected return stays low. But what we don’t want to buy, we may be able to sell it. For investors who already own stocks, they could consider a covered call strategy.
In a classic example, an investor owns 100 shares of stock A and sell 1 call option on the underlying stock. Below are three payoff scenarios:
• If A rises and exceeds call strike, options buyer has the right to exercise (“call the stock”). He will pay at the strike (= 100 shares X strike price). Our investor receives both an upfront premium and the sales amount. However, he gave up all the upside.
• If A moves sideways or rises below the strike, our investor will keep the upfront premium as profit. We may consider this as an income enhancement for owning A.
• If A falls a lot, our investor will incur a loss. However, this loss is due to the risk of owning A, not from selling call options on A.
There are some drawbacks with individual stock options.
• Only the most popular stocks have adequate liquidity. Options trading fees and a wide bid-ask spread will cut into the premium income received by the options seller.
• If you own many stocks and repeat this process multiple times, the problem multiplies quickly. The cost and time required to administer this strategy become unbearable.
• At the end, actual returns could be worse off than theoretical payoff suggested.
Synthetic Covered Call Options with E-Mini S&P and Nasdaq
Is there any alternative to single stock options? We could achieve the same objective with options on E-Mini S&P 500 and Nasdaq 100 futures. I call this Synthetic Covered Call strategy. Compared with individual stock options, stock index options are more liquid and capital efficient.
My logic:
• If you own a basket of diverse stocks, when the stock index rises, your stock portfolio will likely gain in value as well.
• If stock indexes go beyond call strikes, the losses incurred in short options could be largely offset by the gain from the underlying stock portfolio.
• Combining with a stock portfolio, short option on stock index futures has significantly lower risk than selling a naked call.
However, we still need to understand investment risk. It lies with the possibility that the portfolio and market indexes could move in different directions. Investors could run an analysis to determine how correlated their portfolio return is to S&P and Nasdaq returns.
On May 31st, the June contract of E-Mini S&P 500 (ESM4) is quoted 5,299.25. The out-of-the-money (OTM) call strike 5,400 is quoted at 13.75. The options contract will expire on June 21st, the third Friday of the contract month.
• To sell 1 call option, the investor is required to deposit a margin of $11,800. He will receive an upfront premium from options buyer for $687.50 (=13.75 X $50).
• If June futures stays below 5,400 in the next three weeks, the investor will pocket the upfront premium as investment income.
• Hypothetically, if futures price reach 5,500, which is 100 points over the strike, our short options position will incur a loss of $5,000 (= 100 x 50). This will be more than the premium received, but still below the margin deposit.
On May 31st, the June contract of E-Mini Nasdaq 100 (NQM4) is quoted 18,570.75. The OTM call strike 19,500 is quoted at 14.50. The options contract will expire on June 21st.
• To sell 1 call option, the investor is required to deposit a margin of $17,700. He will receive an upfront premium from options buyer for $290 (=14.50 X 20).
• If June futures stays below 19,500 in the next three weeks, the investor will pocket the premium as investment income.
• Hypothetically, if futures price reach 20,000, which is 500 points over the strike, our short options position will incur a loss of $10,000 (= 500 x $20). This will be more than the premium received, but still below the margin deposit.
Option selling is risky. The Fed’s inaction and low volatility give us some comfort here, but we still could be wrong.
The June 12th meeting is 12 days before options expiration. If the market indexes rise sharply, options seller could buy back the options in the open market at a loss. He may be able to prevent the loss from getting too big by closing the unprotected position.
Options traders could find CME’s Options Calculator a valuable tool in structuring their options strategies. The best part, it is free.
cmegroup.com/tools-information/quikstrike/options-calculator.html
Happy Trading.
Disclaimers
*Trade ideas cited above are for illustration only, as an integral part of a case study to demonstrate the fundamental concepts in risk management under the market scenarios being discussed. They shall not be construed as investment recommendations or advice. Nor are they used to promote any specific products, or services.
CME Real-time Market Data help identify trading set-ups and express my market views. If you have futures in your trading portfolio, you can check out on CME Group data plans available that suit your trading needs tradingview.com/cme/
ES1!), E-Mini Nasdaq 100 Options ( NQ1!)Last Friday, the S&P 500 closed at 5,277.5, up 10.6% year-to-date. The Nasdaq Composite settled at 16,735.0, advancing 11.5% YTD.
This year, the chances of aggressive interest rate cuts diminished rapidly amid solid employment data and cooling US inflation. However, these headwinds could not stop US stocks from reaching one new record after another.
Over the past year, the Fed’s official rhetoric has shifted from hawkish to dovish, and then back to hawkish again. But action speaks louder than words. Since the last rate hike in July 2023, the Fed has kept the interest rates unchanged in the last six FOMC meetings.
According to CME Group’s FedWatch Tool, the probability of a no-rate-change decision in the June 12th FOMC is 99.7%. There is an 81.2% chance that the Fed Funds rates stay at 5.25%-5.50% on July 31st. The futures market expects the first 25bp rate cut on September 18th, with a 64% probability (Data as of June 4th).
(Link: cmegroup.com/markets/interest-rates/cme-fedwatch-tool.html)
Fed’s monetary policy has been the dominant driver of global financial market conditions in the last two years. The absence of Fed actions helped reduce market volatility. As a result, the VIX index plummeted from 19.2 on April 15th to 12.9 on May 31st.
Exploring Covered Call Options Strategies
Low volatility suggests that the US stock market is likely to move sideways in the near future. If you own stocks, you may finish the year with a positive return, as the two major indexes have already yielded 10-11% YTD.
If you plan to enter the market now, buying stocks is quite challenging. I personally have a hard time justifying a lofty price while the expected return stays low. But what we don’t want to buy, we may be able to sell it. For investors who already own stocks, they could consider a covered call strategy.
In a classic example, an investor owns 100 shares of stock A and sell 1 call option on the underlying stock. Below are three payoff scenarios:
• If A rises and exceeds call strike, options buyer has the right to exercise (“call the stock”). He will pay at the strike (= 100 shares X strike price). Our investor receives both an upfront premium and the sales amount. However, he gave up all the upside.
• If A moves sideways or rises below the strike, our investor will keep the upfront premium as profit. We may consider this as an income enhancement for owning A.
• If A falls a lot, our investor will incur a loss. However, this loss is due to the risk of owning A, not from selling call options on A.
There are some drawbacks with individual stock options.
• Only the most popular stocks have adequate liquidity. Options trading fees and a wide bid-ask spread will cut into the premium income received by the options seller.
• If you own many stocks and repeat this process multiple times, the problem multiplies quickly. The cost and time required to administer this strategy become unbearable.
• At the end, actual returns could be worse off than theoretical payoff suggested.
Synthetic Covered Call Options with E-Mini S&P and Nasdaq
Is there any alternative to single stock options? We could achieve the same objective with options on E-Mini S&P 500 and Nasdaq 100 futures. I call this Synthetic Covered Call strategy. Compared with individual stock options, stock index options are more liquid and capital efficient.
My logic:
• If you own a basket of diverse stocks, when the stock index rises, your stock portfolio will likely gain in value as well.
• If stock indexes go beyond call strikes, the losses incurred in short options could be largely offset by the gain from the underlying stock portfolio.
• Combining with a stock portfolio, short option on stock index futures has significantly lower risk than selling a naked call.
However, we still need to understand investment risk. It lies with the possibility that the portfolio and market indexes could move in different directions. Investors could run an analysis to determine how correlated their portfolio return is to S&P and Nasdaq returns.
On May 31st, the June contract of E-Mini S&P 500 (ESM4) is quoted 5,299.25. The out-of-the-money (OTM) call strike 5,400 is quoted at 13.75. The options contract will expire on June 21st, the third Friday of the contract month.
• To sell 1 call option, the investor is required to deposit a margin of $11,800. He will receive an upfront premium from options buyer for $687.50 (=13.75 X $50).
• If June futures stays below 5,400 in the next three weeks, the investor will pocket the upfront premium as investment income.
• Hypothetically, if futures price reach 5,500, which is 100 points over the strike, our short options position will incur a loss of $5,000 (= 100 x 50). This will be more than the premium received, but still below the margin deposit.
On May 31st, the June contract of E-Mini Nasdaq 100 (NQM4) is quoted 18,570.75. The OTM call strike 19,500 is quoted at 14.50. The options contract will expire on June 21st.
• To sell 1 call option, the investor is required to deposit a margin of $17,700. He will receive an upfront premium from options buyer for $290 (=14.50 X 20).
• If June futures stays below 19,500 in the next three weeks, the investor will pocket the premium as investment income.
• Hypothetically, if futures price reach 20,000, which is 500 points over the strike, our short options position will incur a loss of $10,000 (= 500 x $20). This will be more than the premium received, but still below the margin deposit.
Option selling is risky. The Fed’s inaction and low volatility give us some comfort here, but we still could be wrong.
The June 12th meeting is 12 days before options expiration. If the market indexes rise sharply, options seller could buy back the options in the open market at a loss. He may be able to prevent the loss from getting too big by closing the unprotected position.
Options traders could find CME’s Options Calculator a valuable tool in structuring their options strategies. The best part, it is free.
cmegroup.com/tools-information/quikstrike/options-calculator.html
Happy Trading.
Disclaimers
*Trade ideas cited above are for illustration only, as an integral part of a case study to demonstrate the fundamental concepts in risk management under the market scenarios being discussed. They shall not be construed as investment recommendations or advice. Nor are they used to promote any specific products, or services.
CME Real-time Market Data help identify trading set-ups and express my market views. If you have futures in your trading portfolio, you can check out on CME Group data plans available that suit your trading needs tradingview.com/cme/
Jim W. Huang, CFA
jimwenhuang@gmail.com
jimwenhuang@gmail.com
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