Tag Archives | naked put

Quiz Answers

Thanks to everyone who participated in Friday's quiz.  I learned some lessons by offering this quiz.

The first is that these polls do not appear on an RSS feed.  For that I apologize.  If anyone has a solution to that problem, I'd appreciate hearing about it.

 

The answers

1) Which of these is the main difference between writing 5 AAPL Dec 280 covered calls and selling 5 AAPL Dec 280 puts?

c) Commissions are higher for the covered call

It's true that the trades are equivalent and it makes no difference which you own.  However, transaction costs are not considered when positions are compared.  Writing covered calls requires payment of two commissions, vs. one for the put sale.  For traders who have tiny commissions, this difference is unimportant.

The trap on this question is the fallacy that selling naked puts is far more dangerous.  Writing covered calls is no different from writing a naked put.  The profit/loss profiles are identical – when the strike price and expiration date of the put and call are also identical.

The fact that so many (17%) chose the 'dangerous' put as their answer suggests that  some basic topics for option rookies are worth revisiting.  This specific misconception should be addressed early in a trader's career.  Look for more on this topic tomorrow

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2) You feel XYZ (no dividends) is headed lower. Which trade is better:

i) Sell Jan 90/95C spread; collect $2 premium

ii) Buy Jan 90/95P spread; pay $3 premium

d)* they are equivalent and it makes no difference

However, in all fairness I want to point out that it is better to collect $300 cash than to pay $200 for the equivalent position.  With interest rates so low, today the answer is that it makes no difference.  But be aware that when interest rates are higher, it's better to collect interest on $300 than to pay it on $200.

*Thus, if you chose 'Sell the call spread' for the reason stated above, consider that to be the correct answer.

The price of XYZ makes no difference.  The two spreads have identical financial outcomes when expiration arrives.  Each can earn a maximum profit of $200 and incur a maximum loss of $300.

For anyone who wants to look more deeply into a detail of the trade, it is better to sell the call spead for this reason:  If you are correct and the stock does decline, the calls expire worthless and the puts expire in the money.  Most brokers get away with charging a fee (and a relatively steep one) for each exercise or assignment.  Thus, selling the call spread avoids paying those two fees – when you are correct in your prognostication.

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3) Rank them in order: most profitable to largest loss

b,a,c,d

Once I amended the question requesting that you enter the correct sequence as 'other' 2/3 of responders had the correct answer.

b) is the most profitable because time passes and nothing happens

a) is next.  It's basically the same situation as b).  The difference is that implied volatility has increased – and that results is less profit for the iron condor trader

c) The 40-point decline is not good, but it is not as bad as

d) the 100 -point rally.  The short call option is now 30 points in the money

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4) Which of the following offers the best alternative for the majority of individual investors?

The two options related answers garnered 80% of the votes.  And those are the two best answers to the question.

c) Sell the entire portfolio and replace each 100 shares of stock with an in the money (delta 70) call option

More than twice as many voters chose d), rather than c).  An explanation is in order.

Buying the puts is straightforward.  The trader maintains possession of his/her portfolio and protects the downside by owning a put option.  However, owing 100 shares of stock and one put option is equivalent to owning one call option at the same strike.  Thus the buyer of an at the money protective put is, in reality, changing the portfolio from long stock to long ATM calls.

Alternative c) also finds the investor owning an all-call portfolio.  The difference is that this time the call is ITM.  The downside is protected because all that can be lost is the value of the call.

c) gives the investor a better opportunity to earn money on a continued rally because he/she owns the 70 delta call instead of the 50 delta (synthetic) call.   

d) affords better downside protection, but costs more.  The other play (c) is equivalent to buying the 30 detla put, and that is less expensive than buying the ~50 delta, at the money, put.

On re-reading this reply, it seems that I am imposing my comfort zone boundaries on this answer.  Obviously if you prefer to own the 50-delta synthetic call than the 70-delta call, how can I judge that it's the 'wrong' answer?

But please be aware that the cost is higher and that the upside is not as good.

Selling part of your portfolio is reasonable, but the real question is:  how much to sell? 

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5)  In your opinion, which two of the following played the most important role in determining your past success as an option trader?

The top vote getters (the poll is still open) had nothing to do with the actual trading.  Instead they were all factors that concerned risk management:

1) Preventing large losses (32%)

2) Following a trade plan (19%)

3) Not trading too much size (23%)

That's a very pleasing result.  Market timing and predicting direction may be something that some traders can do well, but your responses tell me that you not only understand the importance of good risk management, but that you practice it and it pays off in extra income.

Thank you for participating

807

Learned a great deal from your book.  This is especially true regarding Equivalent Positions.  Your chapter was the clearest explanation that I have ever read.  Thank you for making the effort to put out such a fine book." DS

 

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