01 July 2009

Covered Calls and Naked Puts - Same Only Different

Original Content Sigma Options


We all know that naked puts and covered calls are synthetically equivalent... well I hope we all know by now, and we know that a buy write IS a covered call.

My thesis today is that they all may be quite different, not in risk profile, but in the psychology these strategies are a subject of.

Firstly the difference between a covered call and a buy write. Of course there is no official difference, it's long stock and short a call no matter which name you use, but I think there is a difference of inception, the nomenclature different according to the goal of the trader. I think of a buy write as when a stock is bought with the call written at the same time. A covered call I think of as a call written over stock already owned, perhaps for some considerable length of time.

A buy write is entered as a trade to collect the premium (Here I am speaking of general practice, not my practice) and the buy writer is hoping that the stock goes up and is called away. Of course a written put can be used instead, but there are a few reason why the trader doesn't use the naked put. He may have done one of "those" courses. He may not know about synthetic equivalency. His muppet of a broker may not allow him to trade naked puts. This is the sort of trader that scans for high IVs looking for maximum premium (for better or for worse), but he usually doesn't want to keep the stock.

The covered call trader on the other hand, already owns the stock. He probably doesn't want his stock called away, particularly if he has a low cost base and doesn't want a capital gains tax event. As such he is probably writing the call to partially hedge and/or derive some extra income from the premium. His stock is going sideways or perhaps on what he hopes is a short term decline. If the call goes in the money, he is more likely to trade out of the call rather than have his stock assigned.

Please note that these are personal definitions and may not reflects other's thinking.

The naked put trader generally has one of two goals. He either want to just collect premium, so is like our buy writer, or he is writing puts he hopes will end up in the money and wants to be assigned the stock. This second type of naked put trader is more akin, but slightly different to our covered call trader. He is used the puts as part of an overall investment strategy and not really a trader.

All of the above traders may select different strikes and expiries depending on what his ultimate goal is.

So yes, all have the identical payoff diagram when the strike price and expiry are the same, but there are different reasons and psychology that dictate different approaches within the same group of strategies.

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