Covered Calls and Naked Puts Revisited

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When a rookie trader first becomes aware that some positions produce identical profits and losses, regardless of the price of the underlying asset, it's truly an 'aha' moment. 

It's as if a veil has been lifted and the world has become a brighter place.

  Because I believe this is an important concept and truly enhances a rookie's ability to understand options far more quickly, I devoted a chapter to the concept of equivalent positions in The Rookie's Guide to Options.  I also  provided a solid introduction to the topic in some earlier posts.

Because the primary purpose of this blog is to provide an education to option rookies, let's take a closer look at two different strategies: covered call writing and naked put selling.

But first a word of caution:  These two strategies are most beneficial to investors whose only investment experience consists of owning a portfolio of stocks, mutual funds, or exchange traded funds (ETFs).  Each of these strategies is a less risky method for investing in the stock market – when compared with owning stocks.  The investor earns a profit more frequently, loses less often and does well when the market rallies, trades in a narrow range, or even when it undergoes a small decline.  In each of those scenarios the covered call writer and naked put seller outperform their counterparts who simply own stock.

However, these are considered to be 'not-so-safe' strategies.  If the market tumbles, losses can be sizable.  In that respect, losses are similar to (but smaller than) losses incurred by thsoe who own stock.  And upside profits are limited, whereas the investor who owns stock has the potential for unlimited gains.

Nevertheless, these are both very popular strategies because they are safer than owning stock and offer an investing style that is easy to learn.  I use these strategies to introduce rookies to the world of options.  Once these methods are well understood, then I move on to less risky plays.

Comparison

If the simple algebra used in the proof that these methods are equivalent was not enough proof, let's take a look at the profit/loss graph for a pair of equivalent positions.  Although this is not strictly 'proof' I hope that seeing identical graphs goes a long way towards convincing you that these positions truly are equivalent.

Previous posts offered more details about covered call writing and naked put writing ('write' has the same meaning as 'sell' – when the investor is not selling an option that was bought earlier).

To be equivalent, the option part (the call or put option that is written, or sold) of each trade must have these elements in common:

  • The same underlying asset
  • The same strike price
  • The same expiration date

Risk Graphs

APPL Jan 300 covered call


 

AAPL Jan 300 naked put

These graphs are essentially identical.  Any minor difference occurs because the price of the trade execution always plays a role.  Our discussion is based on the assumption that neither trade is made at an advantageous price over the other.  

Interest rates are very low, but it does cost more to carry the covered call position (cash required to buy the position) than the naked put (cash collected when selling the put) and thus the CC should appear to be slightly more profitable by the cost of owning the position through expiration.

One myth that can be destroyed here is that a naked put is riskier than a covered call.  The positions are equivalent.

 

Other positions

These are not the only two option positions that are equivalent.  Keep in mind that calls are puts and puts are calls (all a trader has to do to convert one to the other is add stock – long or short – to any position).

808

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18 Responses to Covered Calls and Naked Puts Revisited

  1. Dimitris 10/12/2010 at 7:01 AM #

    Mark,
    I am trying to make some kind of plan for my trades in my paper trading account and I am kindly asking for your help and advice.
    About 20 days ago (SPY=113.50), using my size position calculator, I bought 40 ICs: SPY Dec 124/126 C, 101/99 P @ 0.50 (excl. commissions).
    Today, 67 days until expiration, SPY=116.65, the IC costs 0.55.
    I have no idea how the market will move in the next months until Dec expiration but if I am forced to have an opinion, I will say that the market will move higher rather than lower.
    Let’s assume that the market will move higher and in two weeks time ( 52 days until Dec expiration) SPY=122. Considering my personal CZ this is getting too close to my call short position. I need to do something. Using the trade analyser of my broker, I estimate that in Oct 26, the 124/126 C spread will cost 0.77 I am thinking to close 1/3 of my position (13 contracts). This will cost $1000.
    At the same time, with 52 days remaining to Dec expiration, I feel that I can take advantage of the move in SPY and sell a credit spread. I can not calculate the Greeks of my position for that date, but according to my CZ the spread Dec 130/132 C looks “safe” enough. This has a premium of 0.20. Using my size position calculator, I find that I have to sell 33 contracts of Dec 130/132. This is a credit of $660. (I am not trying in any way to compensate the cost of $1000 mentioned above).
    If the market moves higher still and the time remaining, until Dec expiration, is more than 30 days, I will try to sell another call spread. If the time remaining is less than 30 days I will close my position.
    Forgetting, for a moment, about my CZ and your CZ which obviously are not the same, does this “plan” look reasonable? Can I improve it?
    Thank you very much for your time and support.

  2. Mark Wolfinger 10/12/2010 at 7:51 AM #

    Dimitris,
    If your broker does not allow the calculation of the Greeks for a different date, tell them how important it is for you to be able to do that. Perhaps they will do something. Interactive Brokers eventually offered that service, after refusing to do so.
    Whoa!. You have a “size calculator” that tells you that “I have to sell 33 contracts…”
    You don’t HAVE to do anything. Trade the size that suits you and your CZ. Come to my webinar this afternoon 5 PM ET for a discussion of this, among other topics.
    Yes the plan is reasonable, but I have some major problems:
    a) It is NOT a good idea to increase position size, and thus, increase risk.
    b) It’s an acceptable strategy to use, on occasion, but not as a regular plan
    c) To sell extra spreads and increase ultimate market risk, your portfolio must have ‘room.’ By that I mean that you do not violate your position size limits for iron condor positions. Ultimate risk is just too high
    d) Selling extra, father OTM, spreads is very appealing. It looks so much safer, it feels better, and if you did not try to recover that $1,000 cost, all those things are good.
    e) BUT – risk of destroying your account has increased because of the extra size. NOTE: In this example, you are moving from 40-two point iron condors to 60. That is a 50% increase in ultimate risk.
    However, this strategy works most of the time. It does as advertised by giving you a better looking position and provides a better return – most of the time.
    Sooner or later, after you use this strategy, your position will require a 2nd adjustment, then a 3rd. At some point you will have too many contracts sold. I don’t advise adding size as an adjustment unless you have margin room, your trade plan allows for extra size, and your cash at risk is still within acceptable levels.
    If you pass these tests, this strategy is ok. But I believe a 50% increase is still too large.
    I beg you not to make this your ‘go to’ adjustment method. As I said, it works so often that it becomes habit forming. It becomes easy to sell extra spreads and believe ‘this is easy.’ This is risky.
    If you, Dimitris, are willing to accept the risk and understand the risk and the probability of incurring a large loss (it’s pretty small), then this strategy is ok. But it is risky.
    Do not forget that.
    It’s acceptable to take on extra risk – when the reward justifies it and you are in position to have extra risk. That will not always be the case.

  3. Dimitris 10/12/2010 at 9:06 AM #

    Mark,
    Thank you very much for your comments.
    The size calculator I use is a simple spreadsheet that I made in Excel. It tells me how many contracts I have to trade keeping always the max possible loss constant (in this case $6000).
    As far as your comment about increasing the size of contracts from 40 to 60 is not quite clear to me. I mean, suppose that I do not have to adjust and instead, I want to add a second trade in my portfolio. If I buy an IC with the same premium as the first one (ie 0.50), using the size calculator, I will buy again 40 contracts. So, I will have in total 80 contracts in this case.
    I started my paper trade portfolio with $200,000. Then I said that I will allocate 30% ($60,000) of the total portfolio for trading options (90 day iron condors). I will risk 3% ($6000 for each trade). When the premium is higher I trade more contracts, when the premium is lower I trade less contracts but the max risk is always the same ($6000). I will make two trades each month (therefore 6 positions at any one time, w/o counting adjustments, in my total portfolio of 90 day expiring iron condors) and I will risk max $6000 per trade or $36,000 for the whole portfolio. This leaves me with another $24,000 available for adjustments.
    Does this make sense?
    Again, thank you very much for your support.

  4. Mark Wolfinger 10/12/2010 at 9:39 AM #

    D,
    1)It’s ok to risk 6k per trade with a 200k portfolio. When you trade a 2-point iron condor and collect 50 cents, your maximum loss is $150 each, or $6000.
    2) When you increase position size to 60 contracts, your maximum loss is now well beyond $6,000. So, how does this fit in with your plan to risk only 6k per trade? It doesn’t.
    3) The fact that you have $24k available for adjustments has absolutely nothing to do with added risk. Some adjustments require additional margin and some do not. That’s why you want to have additional margin room available.
    But, if 6k is your limit, than your entire plan does NOT make sense. Your adjustment plan violates your original plan. Risk exceeds 6k when you cover 13 spreads and sell 33 new spreads.
    4) If your plan is to limit the original trade to a risk of 6k, but plan to violate that limit when adjusting, then to me, this is not a viable plan.
    It will be successful very often. You will like the plan. You will like the results. Then one day your account will self-destruct because you are carrying too much risk.
    Think about what you will do when the rally continues and you now have to cover the other 27 of your original spread and again increase size. Think about what happens when your new spread (100-lots?) gets in trouble. Will you roll these 100 to 150 or 250? What about risk? What about using so much margin?
    Don’t ignore the fact that when one position gets into deep trouble, others may also be in trouble. Are you going to increase size and risk for all of them?
    This is not viable.

  5. msheret@charter.net 10/12/2010 at 9:56 AM #

    Hi Mark,
    I was wondering if you can recommend a software platform. I’ve been using optionetics and LiveVol with Interactive as my broker. I like aspects of all of them but find tying everything together very clumsy. What do you use?
    Thanks
    Mark

  6. Mark Wolfinger 10/12/2010 at 11:03 AM #

    Mark,
    I use only the platform offered by Interactive Brokers, and truly have nothing to recommend. I have not used any platform together than broker supplied.
    Readers: Any suggestions?

  7. Steve B 10/12/2010 at 11:27 AM #

    Think or Swim has a decent platform, especially for paper trading and they have great analyzing tools and chart options.

  8. Peter 10/12/2010 at 12:42 PM #

    Yes, I would also recommend ThinkOrSwim for its analytics.

  9. msheret@charter.net 10/12/2010 at 3:49 PM #

    Thanks I am checking out think or swim I am an IB user but did not know they had analytics

  10. semuren 10/12/2010 at 3:52 PM #

    the rub — while what you say about naked puts being equivalent to covered calls is correct there is a big issue here. In general people trade naked pits differently than how they trade covered calls. Most sell a slightly OTM call for a covered call or an OTM put in a naked put. Those are not equivalent and that is why people view these two strategies as different. In the end it is all about practice, how people actually do things, not about ultimately correct notions. But I do not want to go off on a discussion of epistemology in the social sciences so I will just leave it at that for now.

  11. Alec 10/12/2010 at 5:30 PM #

    Excellent webinar, Mark! Great follow-up, concise and practical info as always, good show 🙂

  12. Mark Wolfinger 10/12/2010 at 5:52 PM #

    Hello,
    You are right. I always stress the notion that the strike must be the same. But I recognize that people love to sell OTM options.
    Thanks

  13. Mark Wolfinger 10/12/2010 at 5:53 PM #

    Alec,
    Thanks

  14. Brian 03/28/2011 at 8:44 PM #

    Ok technically and theoretically they are the same naked put and covered call but since the market is not always perfect we can look at AAPL situation today as an example.
    AAPL trading 350..44

    May 360 OTM calls at 11.50 and same strike puts ITM at 20.55

    No matter what the underlying is at any time before expiry, if you do the maths, you are making on the covered call a $100. One might think it offsets the cost of carry to for the underlying purchased with the covered call, but 100$ to 35k is about 0.02% in 2 months that is about 1.7% annually so you are actually earning on holding to 100 shares to cover your call contract, while with a naked put your liquid money of 35k could be earning maybe 2% yearly interest in saving account in case you get assigned on the ITM put, but you are also paying two trades for the covered call and a third if you sell the shares after expiry of the call or even 4 trades if liquidate your position any time before expiry.
    So actually a naked put ITM is better that OTM covered call. Granted the difference is not big but it still looks cheaper.

    • Brian 03/28/2011 at 8:49 PM #

      For clarification, I meant you are making a 100$ more on the covered call than the naked put, and 100/35,000=0.28% not 0.02% in two months and that is about 1.7% annually.

    • Mark D Wolfinger 03/28/2011 at 11:49 PM #

      Brian,

      I am confused. In the first post you conclude that the put sale is better. In the second and clarifying post, you say the covered call is $100 better.

      The markets may not be perfect, but if there is a discrepancy, the arbitrageurs jump in and make the markets efficient. If the call is priced too high, they buy puts, buy stock and sell the calls until the calls are no longer priced too high.

      I suggest not looking at closing prices. You want to verify that what you see is really true by using live prices during the trading day. So I ask, do you believe that you see this occurring often? I don’t believe that’s possible with the tremendous computing power available to those arbs.

      The math:
      If I write the covered call, I am paying a debit of $338.94 to buy this position. Interest on ~$34,000 for 53 days, @ 0.28% = $95. Total cost = $339.89

      If I sell the put, collecting $2,055, I am buying stock (if assigned) @ $339.45

      That makes the puts a better deal and you said the covered call is $100 better.

      Also: When you sell the put, you cannot place the money in a savings account earning 2%. You must leave it with the broker, earning essentially nothing. That does not make the put sale any better. Commissions may make a difference, but that depends on how many shares are being traded and the cost of commissions. That varies over a wide range.

      However, what if the trader borrows cash from his/her broker to make the trade? Then the interest rate is MUCH higher than 0.28% and that makes the put trade better yet (in comparison).

      Regards

      • Brian 04/09/2011 at 12:03 PM #

        I am not saying one is always better than the other, as you said it all depends on how much your comissions are, if I am assigned for example I pay more than if I buy the stock and if my margin covers the naked put I don’t need to keep my money sitting at the broker’s I can have it earn interest but then again the interest can be lower than the interest you are charged on margin should you sell a covered call when you buy the stocks on Margin, you have to weigh everything in balance and arbitraging of certain traders can make the situation good for most traders but I can still find my own good in choosing one over the other because not all traders have the same conditions with their brokers, especially not us small traders.
        But how often you can find a situation like this, i can say many times, but by the time you compare the prices and enter the first leg of the covered call let’s say by buying the stock first then the prices change on the market and that small opportunity you see can move from green to red.

        • Mark D Wolfinger 04/09/2011 at 8:30 PM #

          falcon,

          Legging into a trade always involves some risk. Buy-write orders can be used to avoid the leg. And of course, when selling the put, there is no need to leg.

          Yes, your individual arrangement with a broker’s can make a difference. And avoiding assignment and having the sold option expire worthless has advantages when it comes to trading expenses.