Naked Puts Ad Nauseam

OK, clearly I have a bee in my bonnet about naked puts at the moment. As we have discussed in the preceding days, a naked put is equivalent to a covered call, vis a vis, a covered call is a synthetic naked put.

The main problem seems to be with the thinking, the psychology around this strategy. Over the weekend, once again I listened to trader friends referring with great fear and loathing about the risks of naked puts, yet waxing lyrical about the virtue covered calls.

It makes me want to smash my head against a wall... actually I wanted to smash their head against a wall, but I would have possibly lost their friendship in doing so. So I imbibed in that favourite English pastime of drinking to excess instead. A tactic which ensures a change of topic to fast cars, football and loose women. Genius... but I digress.

So now I'm back into the mire of markets, economies and managing option positions, I'll preach into the electronic ether, instead of at my friends.

Dean posted a comment below which referred to a thread on the Motley Fool's discussion board. In it was what I thought was a very useful thinking exercise when considering naked puts (and by synthetic implication, covered calls) and once again, it involves synthetics. (Hat Tip BeautifulPlumage)

We know that we can create a synthetic long stock position with options, by buying a call and selling a corresponding put, so we can look at any stock position as having a long call and short put embedded within it.

We can then analyze the naked put option as a long stock position with the short call stripped out leaving only the short put. A covered call can be looked at precisely the same way, as you have long stock with the long call component stripped out, buy writing (selling) the call leaving only the short put, albeit synthetically.

Why would an investor/trader do this?

By implication, the investor is dodging the cost of buying unlimited upside (the call option premium) and electing to collect the premium available in the short put. He is implying that he doesn't believe the stock is going to appreciate in value more than the strike price, plus what the put option premium is going to deliver in the time to expiry. If he does believe the stock is going higher than that point, he is short changing himself.

He also (by implication) doesn't believe the stock is going to fall by more than the strike price plus premium collected, otherwise just stay out, or use a different strategy. However if the stock does fall past this point, at least the loss is less than long stock.

It is a bet that the stock price is going to stay in a range.

Obviously, the put premium has to be adequate recompense for the risk taken, measured against the probability of such moves occurring in the time frame.

There is no new information there and this is all pretty obvious stuff for those with a good grasp of synthetics, but I thought it was an interesting way of looking at these two strategies, and a good way for people whose thinking has been confused by definitive statements that aren't consistent with reality.

Once again, there are various reasons people want to trade the naked put and it's synthetic equivalent (covered call) which may or may not be optimum for their purposes and there are other strategies from which to select. I'm not promoting this as a good or a bad thing. It's just an exercise in understanding.