Last update: July 2021
This melt-up market has morphed into an outright face ripper. Bears are an endangered species and continue to be hanged, drawn, and quartered. It’s a grisly business, but bulls are all too happy to destroy their counterparts if it means fatter pocketbooks. In this epic time of parabolic ascents and nonexistent volatility, the sole and single edge that a covered call has over naked puts is becoming all too apparent.
Typically it’s a dull edge given nary a thought by naked put traders. But these days she’s suddenly sharp – sharp enough to play all my put selling buddies and me for a fool.
Allow me to build the suspense for a bit longer. For the uninitiated, the covered call and naked put strategies are equivalent positions. Sometimes called synthetics these twin cash flow generators boast identical risk graphs. That means they deliver the same profit or loss at every single stock price. In that sense they are indistinguishable. Let’s look at an example.
Imagine you want to join the mad dash into all things inflation-related and buy 100 shares of XOP (oil & gas ETF) at $39.72. To reduce risk and score cash flow, you sell the Feb $40 call for $1.16. Here are the relevant metrics for this covered call:
Breakeven: $38.56, Max Risk $3,856, Max Profits $144
The other route you could have taken is selling the Feb $40 put for $1.40. Here are the key metrics:
Breakeven: $38.60, Max Risk $3,860, Max Profits $140
For all intents and purposes, these positions are identical. Any minor differences in the potential profit can be attributable to the bid/ask spread or carrying costs. Here’s a risk graph overlay of both strategies:
The biggest reason why you hear traders fawn over the naked put is its cheaper cost. Even in a margin account you still have to put up 50% of the stock cost with covered calls. But with the naked put, the initial margin requirement is more like 15% to 20% of the stock price. And that translates into a much higher return on investment.
My go-to explanation for why someone would do a covered call versus a naked put is this: If you already own the stock then, sure, sell covered calls. But if not, sell puts. You can get the same reward for a pittance of the cost.
With the stock market in runaway freight train mode, however, I now have another critical difference I will include in my regular discussion comparing these strategies.
Are you ready for it?
Naked puts require re-deployment every month or you lose your exposure, covered calls don’t because you’re already long the underlying. The lion’s share of the time this probably doesn’t matter, but the few times it does, well, it sucks.
Am I bummed out just because most of the stocks I sell puts on took off after I took profits on my Jan positions but before I entered Feb?
Of course.
Had I been long shares of EEM, XOP, XME, XRT, and the like and not merely short puts I would have deftly rolled my short Jan calls into Feb like a pro. Instead, I rang the register on my Jan puts and waited for at least a mini-me pullback before selling Feb puts. Silly, conservative trader. You should have recognized the melt-up and chased like all the other money-seeking monkeys.
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