Last update: August 2021
On paper, naked puts and covered calls are equivalent positions. Or, as the cool kids say – synthetics. That means they deliver the same profit or loss at every possible stock price. For the relationship to hold true, however, you have to use the same strike and month. Buying AAPL at $192 and selling an Aug $195 covered call is not identical to selling an Aug $185 naked put. It is identical to selling an Aug $195 put.
That means traders that want to create an OTM covered call synthetically have to get comfortable selling the corresponding ITM put.
Ya dig?
Now, lest it’s not obvious, the benefit for selling puts over covered calls is the reduced capital requirement. Most brokers require you put up 50% of the stock price with covered calls but only 20% for naked puts. Less cost translates into a higher return on investment. And you have more capital available to put to work elsewhere.
In practice, I’ve noticed a few differences between deploying monthly naked puts versus covered calls. The one I want to focus on today is the greater psychological toll demanded by the naked put route.
Remember, a system is only as good as the execution. In my experience continually selling puts is more challenging than buying shares and selling covered calls. It’s not a big enough drawback to offset the overwhelming benefit that is the lower capital cost of naked puts, but it is worth talking about.
Let’s compare two cash flow traders.
- Trader A: Buys AAPL shares at $192 and sells the Aug $195 call for $3.70. His max upside is $6.70 if AAPL can clear $195 by expiration.
- Trader B: Sells the Aug $195 put for $6.70. His max upside is also $6.70 if the stock rises above $195 by expiration.
Suppose AAPL rallies to $197 by expiration, but has a price chart that appears decisively overextended.
- Trader A: Buys back the short Aug $195 call for around $2 to avoid assignment and promptly sells the Sep $200 call for $2.50 to keep his adventure moving. Additionally, since the stock is overbought, he is doubly sure to sell a Sep call so he has a bearish position that will offset his loss if the underlying were to retrace from its lofty perch. This means in overbought conditions it is that much easier for a stock owner to sell calls.
- Trader B: Lets the Aug $195 put expire worthless or repurchases it for a few cents. Then he pauses. AAPL is overbought. Were he to mimic the covered call trader he would be selling the Sep $200 call for $5.50. His system says to sell the put to maintain exposure. That’s what he would have done if he were selling covered calls. But his technical forecast says the stock may pull back in the coming days thus providing a better entry point for selling September puts. In the end, he waits.
Then AAPL rips from $197 to $202, and the naked put trader is left watching the rally from the cheap seats. Sadly, his errant forecast upended the plan.
- Selling OTM covered calls in overbought markets = EASY
- Selling ITM naked puts in overbought markets = HARD
See the difference? Even though both positions are identical, it’s easier to stay the course on the covered call position.
One solution, perhaps the best solution, is to simply avoid muddying the waters by thinking too hard about your timing. Just ask yourself what you would do if you were deploying a covered call system. Then act accordingly with your naked puts.
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