The Care and Handling of Covered Call and Naked Put Positions

Hi Mark,

Thanks for presenting this article on a topic related to covered calls.

Steve's question, as well as the oft repeated discussions on
the JustCoveredCalls Yahoo Group regarding whether to (1) close or (2) roll; short puts (in
the case of cash-secured puts [CSP]) or short calls (in the case of
covered calls [CC]) leads me to conjecture that there is an insignificant
difference concerning the "What to do?" question when one compares the
comparable decision facing either the CC or the CSP writers.

2) In a related (albeit different) line of inquiry, it seems to me that
individual investors who are put writers might be slightly more
conservatively oriented in that they tend to sell out-of-the-money
strikes whereas covered calls investors are more likely to be somewhat
more aggressive in that they seem to have a greater tendency to sell
out-of-the-money calls.

Do you have any thoughts on this question?

Are
you aware of any academic research in this regard?

Best Regards,
Jeff

***

1)  Although I've never seen a discussion on this question, it's makes for an excellent blog post:

Let's assume that the reader of this post already understands that covered calls and CSP positions are equivalent (if you are not certain this is true, here's evidence).  That means they offer essentially identical profit and loss profiles.

Do the covered call writer and cash secured put (CSP) seller face essentially identical decisions?

Let's assume the trader is short RGTO Jun 40's.  The covered all writer owns the shares and wrote Jun 40 calls.  The CSP trader sold RGTO Jun 40 puts.

a) When the stock is near 40 as expiration nears, each is faced with a similar decision:

Do you exit the trade, eliminate all risk (associated with significant negative gamma)?  Is this decision affected by whether the position is profitable? 

Do you hold because theta is relatively large with a decent daily reward?

These decisions are identical. The put and call options have the same gamma, vega, and theta.  The positions have identical risk and the traders face identical decisions, even though they don't necessarily recognize that fact.

i) If the traders decide to exit, they make the same decision.  There's not more to say about that choice.

ii) When the CC writer rolls the position to the same strike in July, he/she is selling the call time spread.  The new position is the RGTO Jul 40 covered call.  That position is equivalent to being short the RGTO Jul 40 P.

When the CSP seller decides to roll the position to the next month, that trader also gets short the Jul 40P. 

Thus, each makes the identical play: changing the Jun position to Jul and each has a position equivalent to the other. 

iii) This is a constant.  Regardless of the strike price chosen – as long as each trader sells a RGTO option with the same strike and expiration, each makes an equivalent trade when rolling and each owns an equivalent position.

b) If the stock is not near 40, then either the call or put is relatively DITM and the other is FOTM.

i) If the stock is > 40, then the CC writer is assigned an exercise notice, has no residual position and earns the maximum possible profit for that trade.  The CSP writer sees the short put expire worthless.  This trader also has no residual position and earns the maximum.

ii) If the stock is well below 40, each has a losing situation – but it's the equivalent.  Each has lost an equal amount of  money.  One reasonable action is for the call writer to sell the Jul 35 call – either after the Jun option expires worthless, or prior to expiration.  Why prior?  To collect extra cash NOW, and not gambling on the stock price change between NOW and expiration.

It's also common for the CSP seller to 'roll down' by covering the Jun 40P and selling the Jul35P.   If that's the decision, then once again each has made the equivalent trade.

Bottom line:  Jeff, I agree with your premise: "there is an insignificant
difference concerning the 'What to do?' question."

***

2) I also believe it's true that most option sellers feel safer when writing OTM options.  That would leave the CC writer selling options with a higher strike price (calls) and the CSP writer selling lower strike price puts.

Why does this happen?  In my opinion, it's a result of covered call writers not quite 'getting' the idea behind their strategy.  The need to have a chance to earn a profit on a rally (call it greed) overwhelms their need to minimize loss potential.

Using a $40 stock as an example, if the CC writer understood that writing the Jun 45 call resulted in a position equivalent to selling the Jun 45 put (when it's five points ITM), he/she would be horrified.  Yet, unaware of this equivalence, they write OTM calls month after month.

3) I am not aware of any academic studies, but Odean and Barber have written many papers about the investing habits of individual investors.  If you write to one of them, you may get a reply (I did).

625


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2 Responses to The Care and Handling of Covered Call and Naked Put Positions

  1. Andy 02/27/2010 at 4:03 AM #

    I write covered calls in order to make a small, aditional gain from stocks I want to own “for the long-term” because I am ultimately bullish on them. Thus, my goal is for the covered call to expire just out of the money so I hold onto my stocks.
    I write puts on stocks that I don’t necessarily feel bullish about in the long-run, but feel the price will remain stable until expiration or that the current volatility will decline. Thus, my goal is for the put to expire worthless since I have no interest in holding onto the stock long-term.
    This is why my covered calls are a few dollars OTM, while my cash secured puts are a dollar or two ITM.

  2. Mark Wolfinger 02/27/2010 at 9:34 AM #

    Your plan is typical. Write OTM covered calls. Write OTM naked puts. But you have a different approach by writing ITM naked puts. That’s very unusual.
    These puts are not likely to expire worthless – especially when you are not bullish. It’s likely you will have to repurchase those puts – or accept assignment. That’s not something you want to do for stocks you don’t rally want to own.
    Investors love to see the options sold expire worthless. There’s a psychological boost to knowing you used options to earn an extra profit.
    It’s an illusion. Your two different strategies are more similar than you imagine.
    a) When you write that OTM covered call, you are really selling a naked put. But this time it’s an ITM put with some time premium. You want to collect all, or most of that time premium. When expiration arrives, you hope to be assigned an exercise notice and claim ownership of the stock.
    When you sell the naked put, it’s ITM (by a small amount) and you want it to disappear. You don’t want to claim ownership of the stock.
    But it’s the same strategy. The only difference is the strike price chosen. The only difference is where you ‘hope’ the stock will be trading come expiration.
    In my opinion, this is a blind spot for traders. Most, as you do, see a big difference in writing covered calls and selling naked puts. It’s an illusion.
    From another perspective, you are writing OTM covered calls when you sell those naked puts. And you are writing OTM covered calls when writing ‘real’ as opposed to synthetic calls to trade. Same strategy – with different strike prices.