06 August 2009

Covered Calls - Naked Puts Redux

About a month ago, I was opining opining that though covered calls and naked puts are synthetic equivalents, there may be valid structural or psychological reasons why a trader might use one over the other.

It might not surprise many that I am impressed by my own profundity in that discussion ;). *Some* other arguments on the merits of one over the other leave me underwhelmed however, most particularly when those arguments are chockers full of non-sequiturs, half truths and plain old BS. These of course are all over the place in Option Land, but I'll pick on a recent article published by an option book vendor.

In the article, the author recognised the synthetic equivalency of covered calls and naked puts (rare), but argues the superiority of CCs based on a load of old cobblers, to wit:

Here are the reasons I prefer covered call writing to naked put selling:
1- Many brokerages want the assurance to know that you have the ability to purchase the shares you are obligated to buy when selling the put. Therefore, they will require you to have an adequate amount of cash in your account to cover such an event. You will then have sold a cash-secured put and set aside the same amount of cash as the CC seller.

I don't see this as a disadvantage at all if the goal is conservative premium collection. As the author acknowledges, capital usage is the same. Therefore, there is no valid reason on this point to prefer covered calls.

2- The seller of a covered call captures all dividends distributed by the underlying corporation, the put seller does not. We’re not talking about a huge windfall here, but the cash is better in our pockets than someone else’s.

Just plain incorrect. Option pricing takes into account any pending dividend and option pricing cum-dividend and ex-dividend account for them. If you have a covered call position, the call premium will be cheaper to the tune of the dividend amount. You get the dividend via the stock, but you lose it via less call premium. I have an article on the effects of dividends for further information.

3- Selling covered calls allows the investor more flexibility. The most profit a naked put seller can generate is the premium on the option sale. A covered call writer can profit from the option premium PLUS additional share appreciation if an out-of-the-money strike is sold. That choice is available to the covered call writer but not to the naked put seller.

There is still no difference in payoff. If an OTM call is written, the *corresponding* ITM naked put can also be written, again with the same payoff diagram as the OTM covered call. Synthetic equivalence is maintained no matter what the strike price.

4- Early assignment is not an issue for CC writers because the option premium is not affected and possible additional upside appreciation is incorporated into your profits if an O-T-M strike was sold. For naked put sellers, early assignment could be a disaster. Imagine a stock gapping down, and the stock “put” to us at the $30 strike. The stock is plummeting and heading for the teens! The put seller wants to sell the stock before it loses more ground but perhaps the shares haven’t even hit his account yet. He may have to wait until the next day to sell the shares. One way of getting around this issue is to sell the shares short (selling before actually owning them). The problem with this solution is that average... investors will have a difficult time getting “shorting privileges” from their brokerage firm and may lack the sophistication necessary to manage such situations. Besides, who needs the headaches?

There are a couple of points here:

a) It's true that the naked put might be assigned early if there is zero extrinsic value, however the short put will have a delta of +1, or very close to it, and will be trading like the stock anyway. This will put the trader in a position of a substantial open loss for sure, but the author neglects to inform the reader that the covered call will be in the identical position of a large open loss. Once again, the positions will be the same.

b) The suggested response of shorting stock is incorrect for the stated goal of exiting the position, as you don't know if and/or when you will be assigned. You may just be flipping your deltas and have an open synthetic short call. That's not what the author intended. There is no law that says you have to hold the put till expiry or assignment. The best response if you want to exit the trade before possibly being assigned is just buy back the written put.

5- Those interested in option investing in tax sheltered accounts, will have an easier time establishing such accounts using covered call writing than any other form of options trading.

This isn't my field, but I am led to believe that cash covered naked puts are permissable in such tax sheltered accounts.

If people really want to trade covered calls over naked puts, fine, there may be valid reasons as I stated in my earlier article. No skin off my nose, but let's not justify it with misinformation and bullshit.


Mark Wolfinger said...

I'd love to know which book you quoted because the author is a moron. Or a liar.

To me the naked put is better for two simple reasons:

1) Commissions cost less

2) To exit a winning trade early, the put seller can often buy the put at a very low price ($0.05).

But it almost impossible to unwind the CC at decent price because the market in the call option (now ITM) is too wide.

Wayne said...


I don't want to name and shame the site publicly, but I'll try and find your email and send you the link.

Re Moron or Liar... I think most of these clowns are morons, with a bit of liar thrown in for marketing purposes.


Barry said...

You will probably just consider this semantics but ...

If you are going to analyze covered calls you really should compare them to cash-secured puts not naked puts.

Everywhere you use the phrase naked put just substitute cash-secured put. Just stop using the phrase naked put when talking about covered calls.

Technically how can a naked put and covered call be consider equivalent if you can implement a covered call position but you cannot implement a naked put (for the large majority of covered call writers).

They are close, i.e. same profit/loss characteristics. But they are not identical.

Wayne said...


When there is a discussion of synthetic equivalence, the capital required to enter the individual trades is not considered for a couple of reasons.

1/ Only the risk reward profile is considered, (and non-tranparent considerations such as cost of carry on stock and dividends must be taken into account) the actual capital required is not a factor when looking at synthetic equivalence.

There may be reasons one might use one over the other, which may include the amount of capital required, but that does not effect the fact of synthetic equivalence. I have discussed these things on this blog.

Here's why:

2/ Covered calls (and naked puts) will have different capital requirements depending on the instrument, and on the investor.

An investor on a cash account must pay up the entire amount for the stock.

An investor on a Reg T margin account will only have to put up 50% initial margin for the stock

An investor with a risk margin account (AKA SPAN) will have an initial margin which is significantly less.
See http://sigmaoptions.blogspot.com/search?q=new+margin+rules

Long 500 IBM @ $91.25
Short 5 calls IBM APR 95 @ $ 2.78
Strategy margin is 50% of stock less the short option premium or $21,422.50
Portfolio margin requirement is $5,504.00

If capital required somehow invalidated equivalence. the exact same covered call position under the three cash/margin regimes would be deemed un-equivalent. That is obviously absurd.

Therefore, an investor with SPAN margining will have similar margin requirements, whether using a covered call or a naked put.

The conclusion is that is is not relevant whether short puts are cash covered or not when taking about "synthetic" equivalence.


Barry said...

Yes, they are synthetically equivalence (I went and looked up its actual definition), so what.

I guess (perhaps I'm wrong on this also) what really is being asked is thier any difference between the two.

I contend there is. We will examine the naked put first.

This is purely a derivative instrument. The net result of the transaction will be a transfer of wealth (i.e. no wealth is created or destroyed). Because as everyone knows, or should by now, all derivative transactions are a zero sum game.

Now if you assume the options are fairly valued (i.e. priced correctly by whatever model you use). The net transfer of wealth over the long term should be zero. Otherwise your model is not pricing the option correctly to produce a fair game.

Wow, how can anyone make any money with that game (a rhetorical question)?

Now lets look at a covered call. This involves the actual creation or destruction of wealth. I.e. the underlying stock can go up or down in price.

Lets take a simple OTM covered call that ends up deep ITM.
The stock moving up has created wealth. The CC writer receives some of that wealth plus a wealth transfer from the CC buyer. The CC buyer receives some of the newly created wealth because this option is ITM. Its a win-win for everyone (yea).

The downside, well wealth can just as easily be destoyed (stock price decrease).

So to summarize, a covered call involves the creation/distruction of wealth. A naked put (cash-secured put) involves the transfer of wealth only.

To me this is a fairly significant difference, your mileage may vary.

Wayne said...


If you're more comfortable trading CCs rather that naked puts on that basis, Godspeed to you. I'll trade either depending on the circumstances. However much I'd like to argue the creation/destruction of wealth mantra, another time maybe.

A couple of points:

Supposing trader A puts on a covered call and trader B sells a naked put... same strike, same expiry and same size.

If the stock expires ITM on the calls and therefore OTM on the puts, and that Trader A is assigned, both A and B will be share-less post expiry as the CC writer will have his shares called away.

Likewise, if the stock expires OTM on the call and therefore ITM on the put, both A and B will have shares. A will keep his shares and B will have shares put to him.

(assuming ITM options are not traded out)

So not only will the financial result be the same, the ultimate position post expiry will be the same as well.

Ergo, your creation/destruction of wealth mantra takes on new dimensions as the trader's overall strategy progresses. The put trader *may* be attempting to acquire stock... and the CC trader *may* be trying to exit. This is all stuff we cannot make assumptions over with the raw position

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