Covered Calls Vs. Naked Puts?

Shares plus (Covered) Calls Vs. Naked Puts?

Is there any difference between a covered call (buying a stock, selling call against the shares) and selling a naked put?

NOTES

A “put” is an option contract giving the owner (buyer) the right, but not the obligation, to SELL the underlying stock at a set price within a specified time. The BUYER of a put bets that the underlying stock will drop below the exercise price before the expiration date. BUYING a put is similar to taking a short position because it is betting the stock goes down, and paying for the right to sell it at a higher price. 

SELLING a put is similar to taking a long position because the SELLER is promising to buy the stock at a lower price if the stock drops below that price. The put seller is betting on higher prices, and agreeing to buy the stock at a lower price if it drops. 

By a “naked put,” we mean there is no offsetting short position in the stock. A securities position that is not hedged from market risk is “naked.” A covered position is hedged from market risk. Potential gain and potential risk are greater when a position is naked vs. covered. (Investopedia)

Shares plus Covered Calls or Naked Puts?

Courtesy of Paul Price

One of life’s beautiful equations is the way certain seemingly unrelated transactions can effectively be balanced in terms of risk/reward. Most investors are entirely comfortable selling covered calls on shares they own. Many of these same traders would never consider selling (writing) naked puts on the same underlying company.

A covered call is a call written (sold) against an underlying long position in a stock. For example, if we own 100 shares of ESRX, we can write one covered call against it. Each call represents 100 shares of stock. A put is a contract to sell 100 shares of stock at a certain price, the strike price. 

These option strategies are largely equivalent. 

Let’s analyze these two situations separately. I’m going to use one of our Virtual Value Portfolio components, Express Scripts (ESRX), in my example. The same theory would apply to any underlying shares and the associated options.

We could buy 100 ESRX @ $53.82 while selling a Jan. 2014 $55 call for $4.80 /share. Our net out-of-pocket expense would be $53.82 – $4.80 = $49.02/share. 

Maximum upside: If ESRX closes at $55 or above on Jan. 17, 2014. The call would be exercised. We would sell our 100 shares for $5,500 total. Writing (selling the call) limited our upside to $55/share by obligating us to sell at $55 even if ESRX is trading higher. 

If ESRX reaches $55 or higher, we sell it at $55 and make $1.18 on the stock; we keep the $4.80 for selling the now worthless call. That’s a profit of $5.98/share on a $49.02/share outlay – a 12.2% gain.  

Investors could liquidate at expiration with a $4.80 per share gain even if ESRX stays at $53.82. That represents a 9.8% cash-on-cash profit on a stock that went nowhere. We keep the $4.80 for selling the call, and we keep the stock if the price is less than $55 at expiration. 

Break-even: If ESRX remains below $55 on expiration date, we would break-even with ESRX at $49.02 (our initial outlay). That would be 8.9% below the price of ESRX when we initiated the trade. If ESRX is above $49.02, we make a profit. 

Worst-case scenario: If ESRX goes to zero, we would lose $49.02 per share.

ESRX option prices

In summary:  Buying 100 shares and selling one call leaves traders with limited upside (+ 12.2%) and moderate downside protection – up to an 8.9% drop in share price from the trade’s inception would cause no loss. Maximum risk was reduced from $53.82 (the original purchase price) to $49.02 per share.

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Instead of buying 100 shares of ESRX and selling one call, let’s simply SELL one Jan. 2014 $55 put for $5.85. Selling a put has the following risk/reward profile:

Maximum profit: If ESRX closes at $55 or higher on Jan. 17, 2014. Express Scripts needs to rise by 2.2% or more for the short put to expire worthless. We would then keep the entire $5.85 premium per share ($585 per contract) with no further obligation.

Break-even, or better, is possible on a drop to no lower than $49.15. Break-even is at $49.15. ESRX could fall 8.6% below its price at the trade’s inception, $53.82, without turning into a loss. 

If ESRX remains unchanged from the original price on option expiration day, the put sellers could keep almost 80% of the original premium received by simply closing out the put just prior to expiration.

Maximum risk: $49.15 /share. That would mean ESRX became totally worthless.

ESRX buy-write versus simple put sale (1) 

Prem = premium (the amount collected from selling the put)

Both techniques offer very similar trade profiles. 

Screen Shot 2013-01-31 at 1.52.59 AM

Margin, and cash requirements and tax treatments would vary more than the actual risk/return ratios. I use both ways to structure option trades on a regular basis.

Disclosure:  Long ESRX shares

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Comments

  1. I am really still going through the 2 techniques but this is my take after selling naked puts for about a year. Essentially the risk profile is the same but there is one big difference that really makes covered calls better. With naked puts, you have a time risk. That is to say that if you sold a naked put and the stock has fallen below the strike, it must recover before expiration or you take a loss or reduction in profit. However with a covered call, the risk is if the stock falls below the strike. The thing is that there is no time risk in the stock. The stock fell so you have paper losses but the covered call has now become worthless. Not only that but to take a true loss for a month, the stock must close twice the original intrinsic value below the stock price. Case in point.
    Amazon is at 347.95. 300 puts are 2.15 and 300 calls are 49.90 with time value of 1.95. This means you make $0.20 less but you have downside protection of 47.95 that you don’t have with the put and really you should never lose because if price does go to 300 then you have your call that you can roll down for a huge profit. Essentially you should always make money and in some cases make a lot. You should never lose. The only exception would be a big gap down of twice your intrinsic value.

    • Dr. Paul Price says:

      In your example with AMZN @ $347.95 at trade inception.

      Downside protection on the $300 put = the drop of $47.95 to the $300 strike price Plus the $2.15 per share of put premium = $50.01 per share. That is very slightly more downside protection than you get by selling a cocvered call for the $49.90 you quoted.

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