Naked Puts vs Covered Calls

Question - Naked Puts vs Covered Calls

I've heard that covered calls and naked puts are very similar trades. Even identical. Can you explain this? What's the difference between short calls and short puts?



Answer

It's true that short calls (covered calls, naked calls) and short puts (cash secured puts, naked puts) essentially have the same risk-reward profile. But let's look at a quick example to illustrate what that means.

On 10/14/09, SBUX closed at $20.54/share. The final relevant bid-ask numbers on the option chain were:

  • $1.43 bid price for the NOV 2010 call at the $20/strike
  • $0.89 bid price for the NOV 2010 put at the $20/strike

Now let's imagine a couple of scenarios (all commissions are excluded for convenience). In both scenarios, let's assume that the stock price at the November expiration, after zigging here and zagging there, ends up right back at the October 14th closing price of $20.54/share.

Trader A employs a buy-write strategy on SBUX, purchasing 100 shares at $20.54 and simultaneously selling the $20 call at the bid price of $1.43 which results in a cash infusion of $143.

Since the stock closes at the November expiration in the money at $20.54, Trader A is obligated to sell his or her shares at the $20 strike price. This results in a $54 capital loss which is offset by the $143 received in premium.

Trader A's net profit therfore equals $89 ($143 minus $54).

Trader B, on the other hand, decides to write a naked put on SBUX at the same $20 strike and the same November expiration month. Trader B writes the put at the bid price of $0.89 and receives $89 in cash. Trader B owns no shares.

And since we're assuming for this example that SBUX closes out of the money at expiration at $20.54/share and therefore worthless, Trader B's final profit then is the $89 premium received.

It doesn't always work out this neatly, but it's usually very close. You can experiment yourself and calculate different scenarios yourself (what happens if SBUX closes at $18/share? Or $22/share? Or what if a different strike price was chosen?). You'll see that, as promised, the risk-reward profiles are essentially the same.



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