Tag Archives | covered calls and naked puts

Equivalent Positions

It may sound simplistic to say this, but it is important for rookie traders to have a good feel for the positions they own. Of course everyone sees his/her specific position, but many times the investor has a better feel for the risk/reward profile for any position by looking at it from an alternative perspective.

For example, the simple collar position seems to be a nice, safe, conservative position. And it is. However, if you own such a position, I believe that looking at it from a different perspective would give you a clear picture of the position that you “really” own.

Collar Example

    Long 100 shares of XYZ, currently trading near $100 per share
    Long one XYZ May 95 put
    Short one XYZ May 105 call

Equivalent position: Short one put spread

    Long one XYZ May 95 put
    Short one XYZ May 105 put

If you are not yet aware that owning a collar is equivalent to being short a put spread, read the discussion and proof at my about.com site.

In my opinion, when you look at a position that shows which put you are short, you have a good understanding of how the position loses money: Obviously when the stock price declines from its current level ($100). Although the collar owner may be similarly aware of risk, it is possible that the 3-legged spread is too complex and the true risk/reward picture may not be clear.

The reason this concerns me is that investors who would benefit from using collars tend to be stock investors who adopted the collar to gain some portfolio protection. They are not typically “traders” who use, and understand, how options work.

More than Collars

My emphasis is always on education for newer option traders, and the importance of understanding how some positions can be equivalent to others is a topic that is worth repeating.

Additional posts on this topic:
Covered Calls and cash-secured naked puts
Introduction to equivalent positions
More on equivalent positions
Yes, equivalent positions are equivalent

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