Advantages of Writing Naked Puts Over Covered Calls

Question - Writing Puts vs Covered Calls - Which is Better?

Since covered calls and naked puts essentially have the same risk-reward profile, are there any advantages of writing naked puts instead of covered calls? Which is better? Or is it just a matter of preference?



Answer

Short Answer: In general, writing naked puts allows you to leverage more positions (and without paying margin interest) than you can writing covered calls.

Long Answer: It's true that writing naked puts essentially has the same risk-reward profile as writing covered calls. But there can still be important differences in the two strategies depending on how you define "naked put."

Remember that when you write, or sell, a put, you are entering into an agreement whereby you give someone else the right to sell you 100 shares of their stock at a certain price (strike price) by a certain date (expiration date) in exchange for a one time cash payment, or premium. You are essentially acting as an insurance company on someone else's stock.

Generically, this is called a short put. Technically, it's also called a naked put. What makes it "naked" is the lack of another offsetting option position to hedge against the inherrent dowside risk of the trade.

Presumably, this would involve a complementary long put position at a lower strike price (and with the same expiration date) which would then form the credit spread known as a bull put spread.

A cash-secured put is simply a short or naked put where you have enough cash in your brokerage account to buy those 100 shares of stock without the use of margin at the strike price should the put be exercised.

Some people consider a naked put to be any short put where you lack the cash to pay for the underlying stock in its entirety should the put be assigned to you. But technically, that's not the case.

Still, the distinction between a cash-secured put and a non-cash-secured put is very important. When we say that a naked put and covered call are essentially the same trade, we're really talking about cash-secured puts.

Whether you consider it an advantage or a disadvantage, the biggest difference between writing puts vs writing calls is that you can usually write a lot more puts than calls. It will depend on your broker, of course, but in general, any non-retirement account approved for option trading, by definition, is also approved for margin.

And it's that margin that makes all the difference.

If you have $10,000 in cash in your brokerage account that's been approved for both margin and options, you could theoretically write covered calls on $20,000 worth of stock (in 100 share lots, of course). But you would also be charged interest on the $10,000 of margin you used.

Alternatively, you could write puts instead (and, in general, more of them) and avoid ever having to pay a penny in margin interest. How much "option buying power" you will have access to will depend on a number of factors. Consult your broker - the formulas used are both complicated and may vary from broker to broker.



Don't Overleverage!

Finally, I would like to remind you that overleveraging is usually not a benefit any more than 100 proof alcohol is a benefit over 50 proof alcohol just because you can get a lot drunker a lot faster.

So while some might consider the ability to overleverage to be one of the advantages of writing naked puts over covered calls, I'm not one of them.

In my own Leveraged Investing approach, I highly recommend cash-secured puts over the non-cashed-secured variety. Overleveraging is just too big of a gamble, especially when you come to realize that true (options-enhanced) investing is simpler, easier, and often just plain better than speculation/trading.



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