One of the interesting
features about options is that there is a relationship between calls, puts, and
the underlying stock. And because of
that relationship, some option positions are equivalent – that means identical
profit/loss profiles – to others.
Why is that important? You will discover that some option
combinations – called spreads – are easier, or less costly to trade than
others. Even with today’s low
commissions, why spend more than you must?
The basic equation that
describes an underlying and its options is: Owning one call option and selling one put option (with the same strike
price and expiration date) is equivalent to owning 100 shares of stock. Thus,
S = C – P; where S = stock; C = call; P = put
If you want a simple proof
that the above equation is true, consider a position that is long one call and
short one put. When expiration arrives,
if the call option is in the money, you exercise the call and own 100
shares. If the put option is in the
money, you are assigned an exercise notice and buy 100 shares of stock. In either case, you own stock. NOTE: If the stock is at the money when expiration
arrives, you are in a quandary. You
don’t know if the put owner is going to exercise and therefore, you
don’t know whether to exercise the call. If you want to maintain the long stock position, the simplest way out is
to buy the put, paying $0.05, or less, and exercise the call.
Example of equivalent positions
There is one equivalent
position that you, the options rookie, should know because these are strategies
you are likely to adopt.
Take a look at a covered call
position (long stock and short one call), or S-C.
From the equation above, S –
C = -P. In other words, if you own stock
and sell one call option (covered call writing) then your position is
equivalent to being short one put option with the same strike and expiration. That position is naked short the put. Amazingly some brokers don't allow all
clients to sell naked puts, but they allow all to write covered calls. The world is not always efficient (you
already knew that).
Thus, writing a covered call
is equivalent to selling a naked put. This is not a big deal to anyone who is an experienced option trader,
but to a newcomer to the world of options this can be an eye-opener.
The more you trade options, you more you will become aware of other equivalent positions. You may even decide to play with the equation for yourself and discover others.
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