Many of our students, after following our step-by-step criteria before considering such a position, want to sell naked puts on stocks experiencing extremely high volatility. We are staunch proponents of risk averse trading, but there are times when selling naked puts make sense.
However, often brokers try to steer them away from the sale of a naked put because of risk considerations, and instead, try to get them to buy a covered call in its place. Huh? This is akin to saying, “Don’t buy six call contracts, buy a half dozen instead.” A covered call and the sale of a naked short put are one and the same.
Amazingly, many brokers have different risk levels that need to be approved before they will allow the use of a certain strategy. Often, the covered call is the first thing brokers will allow a client to trade because it is deemed safe. The sale of a naked put is the last thing that is approved since it is “ultra risky.” Again, huh?
If you are new to options, you understandably may not know the difference between a short put and a long covered call (long stock and short call). Even if you are a veteran to options trading, you may not know that the two are simply synthetics of one another. Do not be embarrassed if you didn’t know this. You can save a lot of money by asking simple questions and lose it by being silent when you don’t understand a potential trade.
We will use Apple, Inc. (AAPL) as a case study, but any stock or index would work exactly the same way. It does not matter how many days there are until expiration, or what the volatility of the underlying is because it will still work exactly the same way as the example being shown.
On March 5, Apple closed at $219. The price of the March 220 put was $4.75; the price of the 220 call was $3.75.
How does the sale of the 220 put differ from the purchase of 100 shares of stock combined with the sale of the 220 call (thus a covered call)? If the break-even graph at expiration differs from the profit and loss of the two positions at any time in any way, then the broker was correct. However, it is our contention that they are exactly the same. Let’s see who is right.
“Apples to apples” illustrates what each component in our comparison is trading for at expiration through a $100 range in the underlying stock price (you could plug in any number and the results will be the same). The fourth column in the table represents the value of the covered call (long stock/short call), while the fifth column represents the value of the put sale at expiration. Looking at the fourth and fifth columns (highlighted in yellow), you will notice that there is no difference between the covered call and the put sale regardless of share price.
The margin on the two positions should be the same, though arrived at from different points, and the covered call position requires two trades, so you will be paying extra commission.
Random Walk is not discouraging or encouraging the sale of a naked put or a covered call. The article is meant to demonstrate how they are the same position. To achieve long-term success, you should know what you are trading before you enter into a position.
If you are not scared of covered calls, you shouldn’t be scared of naked puts. And if an educational company or broker tells you never to sell a naked put or that the covered call is a safer strategy, then you know it is time to run.
Alex Mendoza is the chief options strategist with Random Walk, which has produced numerous articles, books and CDs on options trading, including a book on broken-wing butterfly spreads. Visit their Web site: www.RandomWalkTrading.com