I think I could write about covered calls and naked puts every single week and still have plenty to say at the end of the year. There’s just so much nuance and various angles of explanation that provide a deep well to draw from. I recently highlighted the synthetic nature of these twin cash flow strategies (see here). The message prompted an interesting question from Casey:
I will try this out but I am a little confused only because in a covered call strategy you want the price action to stay above the long position and below the short position whereas a short put you want the chart to rise only to expire worthless. What am I missing?
Before I dive into the answer, let’s make sure we all understand Casey’s comment. Suppose we’re comparing buying a $100 stock and selling a Sep $105 covered call to selling a Sep $105 naked put.
Casey is saying that the covered call trader wants the stock to stay above $100 (the long position), but below $105 (the short position). I can think of two reasons why a covered call trader would say they want the stock to remain below the call strike price ($105).
One: They don’t want to be assigned and have their beloved stock taken away.
Two: If the stock rises too far above the call strike then they will suffer the emotional drag of knowing they underperformed. That is, they made less money than had they not sold a covered call.
Can we say, then, that what a covered call really wants is what Casey says – to sit below the call strike?
Maybe. But not if their goal is to make as much money as possible. If that’s what they want then the ideal scenario is to have the stock rise above the call strike so they capture the max reward.
It’s like asking someone if they’d rather make $100 or $150. The answer can be that simple.
So, if I buy a stock at $100 and sell a $105 call, then the best case scenario and the one I’m gunning for is for the stock to sit above $105 at expiration. Now, I’ll agree with you that I probably don’t want the stock to go too far above $105 simply because then I feel like an idiot for having capped my profit potential too quickly.
Capturing Max Gain + Feeling Like a Dum-Dum = Good
Capturing Max Gain + Not Feeling Like a Dum-Dum = Better
With this perspective in mind, can you now see how a naked put seller’s objectives are the same as a covered call trader? If they both seek to capture max gain, then they both want the stock to rise above the option strikes.
One more thing.
If we set the emotional angle aside for a moment and focus on how fast we make money, we can actually argue that the best case scenario for a covered call is to have the stock immediately skyrocket. If I buy the $100 stock and sell a Sep $105 call and then the stock rips to $115 tomorrow I’ll probably be close to my max gain even though there is still over a month remaining to expiration.
It’s like asking someone if they want to make $150 in two days or if they’d rather wait for six weeks. I’ll take my profits pronto, thank you very much.
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