"Naked" Puts: An Alternative to Covered Calls
Writing Puts: An Alternative to Covered Call Writing
When you write a put on a particular stock with a certain strike and expiration, you have a position that has very similar gain and loss potential as a covered call on that same stock with the same strike and expiration.
In this report, we show an example in which the put write combined with cash would be less risky and better profit potential than a covered call on the same stock with the same strike and expiration. Lastly, we will discuss different ways to control the risk of writing puts.
Two Equivalent Positions
When you write a "naked" put or write a covered call, you are really selling time premium in return for limited gains on the upside and unlimited exposure on the downside. Usually, for calls and puts of the same strike and expiration, this time premium, net of interest and dividends, is extremely close.
There is a theoretical as well as a practical reason for these time premiums being so close. The theoretical reason is that call and put premiums cover essentially the same risk (of the stock making a big move) regardless of whether you are bullish or bearish.
The practical reason is that option market makers arbitrage between calls and puts, bringing the time premiums of the two into line.
Here is comparison of a recommended put write and its corresponding covered call.
CLICK HERE FOR THE FULL-SIZED TABLE
In Table 1, we have selected the Biovail Corp. April $40 put write and covered call, both recommended when the stock was at $42.50. The April $40 put was slightly out-of-the-money with a premium of $3.30. The April $40 call was slightly in-the-money at $5.60.
Notice that both positions have almost identical dollar payoffs at different stock prices at expiration. Also note that when we calculate the return of the naked put write, we factor in the interest on the cash balance that would be required to fully collateralize the put write at its strike price.
On the April expiration date, should the stock have fallen by 25% to $31.88, the covered call would lose $503, while the naked put would lose $465. If the stock ends up at or above the $40 strike price, the covered call will earn $310, while the naked put will earn $348.
In this example, the short put has the advantage over the covered call. Also, when choosing between the two strategies, you should factor in the commissions that you would need to pay to close out your short call at expiration (if the stock is above the strike).
Here, you need to consider your own expectations. If you expect the stock to end up above the strike price, then the short put may be the preferable to the covered call. If you expect the stock to end up below the strike price then the covered call may be the way to go.
Continued In "Part Two: Looking for Opportunities"
Posted By: Value Line
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