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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