More on the equivalency of covered calls and naked puts

A regular commenter, semuren, recently offered a comment that made an important contribution to a discussion:

"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 puts differently than they trade covered calls. Most sell a slightly OTM call for a covered call or an OTM put as 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."

***

I have often stated, and sometimes offered proof, that the two option strategies: writing covered calls and selling cash-secured, naked puts are equivalent.

When positions are equivalent, the profit/loss profiles are identical.  In the real world, the pricing of options may allow one strategy to offer a slightly higher profit than the other, but that can be ignored for a theoretical discussion.

The one qualification that I mention is that the covered call and put must have three characteristics in common:

  • Same underlying asset
  • Same expiration date
  • Same strike price

For example, when the stock price is 38, that means that writing the Nov 40 covered call provides the same result as selling the Nov 40 put.

That statement remains true.  But in a practical sense it's not helpful to the majority of  individual investors/traders.  If it's true, why is it not always helpful?

As semuren mentions, most people who adopt these strategy are oblivious to the concept of equivalent positions, and tend to sell options that are out of the money.  There is a good psychological reason for doing so.

Traders, especially inexperienced traders, get a certain satisfaction out of seeing the options they sold expire worthless. Such results are 'pleasing' because a trade was made and completed profitably. To many traders, that's all that matters. It gives the trader a psychological boost.

The fact that the trader may have lost money on the overall position (example, sell a covered call, collect $200 in premium, and lose $500 when the stock price declines) is ignored.  The satisfaction comes from earning money on the call sale.

The experienced trader does not look at writing covered calls as two separate trades. It's a single position and the trader manages the position and its risk accordingly. This trader  understands that a loss has been taken and that there is no psychological boost in that.

Nevertheless, Options for Rookies is designed to guide beginnes towards making good investing/trading decsions, and the equivalency of covered calls and selling cash secured puts is important.

Expiring worthless

Because of this preference to make a trade in which the option expires worthless, both trades are most often made by writing OTM options.

Thus, the covered call writer sells the Nov 40 call and the put seller writes the Nov 35 put.

Those positons are not equivalent.  Although the equivalency issues is very important in understanding how options work, in this example, it's not really an importance trading principle to the rookie trader. 

That's because that rookie seldom considers selling the Nov 40 put.  In this trader's real world, the trade choices are the Nov 40 covered call and the Nov 35 put sale.

Again, it's crucial to an options education to understand equivalence.   However, there are times when theory gets in the way and may confuse a new trader.

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7 Responses to More on the equivalency of covered calls and naked puts

  1. Julien 10/15/2010 at 9:13 PM #

    Thanks for covering this topic in more detail.
    I have recently purchased some covered calls and the reasons for choosing covered calls rather than selling the equivalent puts is that if there is a big drop in the underlying than it is easier to get out of the stock for a better price than it would be to buy back the put option. I believe this would apply more to illiquid options where there are larger bid/ask spread on the put options. Mark, would you agree with this theory or not? (I do understand that buying back the call would cause similar problems with bid/ask spreads in thinly traded options. However with the delta being minimal if the stock drops far away for the call price, then presumably buying the call back is not as urgent)
    Also, another advantage of the covered call is that one is entitled to dividends on the underlying.

  2. msheret@charter.net 10/16/2010 at 11:46 PM #

    Your risk graphs look great, what software do yo use?

  3. Mark Wolfinger 10/17/2010 at 6:19 AM #

    Julien,
    Yes, it is easier to unload the stock than to buy the put.
    Agree, the call would be less difficult to buy than the put. Not as urgent – only if broker allows you be to naked short call options. Not all allow that.
    If the options are thinly traded, the slippage may cost more than the extra commissions involved with writing covered calls.
    Dividends should not count. They should have been priced into the premium collected, when selling the puts.
    Regards

  4. Mark Wolfinger 10/17/2010 at 6:22 AM #

    Mark,
    I use Risk Navigator, offered by Interactive Brokers to their customers (or anyone who opens a paper trading account.)

  5. Petros Telos 10/18/2010 at 3:30 PM #

    The reason why the naked put works for me better than the covered call is the cost of carry, when using leverage instead of cash. The put costs me no carry charges unless assigned. At 4% interest, that makes a substantial difference.

  6. Mark Wolfinger 10/18/2010 at 8:11 PM #

    Petros,
    It does make a substantial difference.
    However, the option prices should be rational. In a rational world, the covered call writer collects just enough extra premium to compensate for paying that cost of carry.

  7. Petros Telos 10/18/2010 at 8:29 PM #

    Thanks for the answer. I appreciate your website as one of the best resources for learning about options. Cheers.