Covered call vs.

naked put dilemma

In this turbulent market “hedged” equity trades become popular, where you buy 100 shares of stock
simultaneously writing an at-the-money call on this stock. For example (quoted from
http://www.marketintelligencecenter.com/articles/660559 ) : “USB Capital closed at $30.65… For a
hedged play on this stock, look at a Dec '08 30 covered call (USB LF) for a net debit in the $27.15 area. … This
covered call has a 127 day duration, provides 11.42% downside protection and a 10.50% assigned return rate
for a 30.17% annualized return rate.”

In this example, if USB stays above $30 by December expiration, the call will be exercised and the stock called,
but you will make the 10.5% profit on the call premium. If the stock is trading between $27.15 and $30 in
December you both book a smaller profit and get to keep the stock. If the stock declines below $27.15 you will
have to manage the loss in some fashion.

The question that gets perpetually asked is: why not just sell short put instead of the covered call combination?
(E.g. in the above example, why not just sell Dec ’08 30 put [USB XF] for a pre mium in the $3 area?)

Well, short puts require a different loss management style, and in some situations, a more advanced
trade maintenance. In this essay I take a quick glimpse on whether we should be concerned about such
situations.

Discussion

One thing you would be likely to learn early in your equity options study is that “a covered call is the
same thing as a naked put”.

What people mean by saying that is: the Profit/Loss profile of a covered call at the expiry date is the
same as that of a naked put.

(See, for instance, discussion in http://www.callwriter.com/coveredcallmethod.htm )

Investing gurus occasionally wonder why brokers allow inexperienced traders to write covered calls but
not naked puts (e.g. Ken Fisher in his famous “The Only Three Questions That Count…”). The answer in
fact is very simple – the brokers are covering their bottom…err…lines.

The real difference between the covered calls and the naked puts is the different risk-management style.
Specifically we must consider the assignment (including early assignment) management and managing
the gap-down risk.

For covered calls these are two different things. For the call position the assignment happens on the
upward move of the underlying and it sort of takes care of itself – the long stock and the short call
cancel each other resulting in cash credit to the writer’s account.
The gap-down of the underlying through the break-even point is painful for both the covered call and
the naked put, but for the naked put it also creates a dilemma which needs to be resolved very quickly,
because the decline of the stock can trigger an exercise, which may end up in a margin call. Unattended
margin call can have a devastating effect on writer’s account. (That’s why brokers frown when a part-
time trader is wanting to write naked puts.)

So for the rest of this essay I am considering only a cash-secured short put, which is a short put plus
enough cash locked in the account to cover the purchase of the stock on exercise (for example, each
$100 standard short put contract is secured by $10,000 in cash). This seems to bring the covered call
and the secured put on equal footing – there you have money invested in stock, here you have roughly
the same amount of money locked.

However, it turns out that for full risk-equivalence of secured put to a covered call the writer still needs
a naked shorting privilege (and probably a margin privilege) on their account. This shows in the gap-
down scenario. Suppose that the stock falls below the break-even point for reasons that question your
assumptions for owning the stock in the first place. In case of covered call you now want to reduce the
position in the stock you already own, in case of the short put you now have to counter the assignment
of the stock you no longer want. If the stock continues the decline you may start taking losses by selling
parts of your stock holding and thus reducing the market exposure. (Depending on your broker, you will
either have to buy back the short call at some profit or try and hold on to it.) In case of short put you
don’t have the stock on hand (although it is quite possible that the – unwanted - shares will hit your
account next morning), but , to mirror the covered call risk management, you can start selling the stock
short. That’s where you need the shorting privilege.

With a conservative brick and mortar account it may so happen, that there is nothing you would be able
to do to offset the deepening put exercise loss.

Examples

Let us look back one year and try to gauge the extent of gap-down risk for certain naked puts.

The historical data on early assignments is very hard to come by, so I just filtered S&P’s 1500 12 month
data for obvious cases where the stock price falls (through one or more standardized strikes) on an
expiration Friday. The filter found about 100 put contracts that were obviously affected by the stock
price declines. I believe that there should be at least as many instances of early assignment situations
(that the simple filter could not find).

Here are the examples I ended up with.

Drop in HAR on 9/21/2007 was such that all the short puts between $85 and $110 would have been
wiped out. Also in trouble on 9/21/2007 were POOL $25, POOL $27.5 and RL $80 puts.
On the merry Friday of 10/19/2007 the following short puts were in trouble:

AYI $45, BHI $95, CERN $60, CRR $50, DVN $90, ESI $125, EXH $85, FMC $60, GS $220, GS $225, HANS
$65, MER $70, MMM $100, NOV $70, NTG $55, OII $80, PENX $35, SII $70, SLB $100, SLB $105, SLB
$110, SNDK $45, SNDK $47.5, SNDK $50, SSP $130, SSP $135, TGIC $10, TGIC $12.5, TGIC $15, TXI $75

On 11/16/2007: AVB $105, AVB $100, FDX $100, SNS $12.5, THO $40, XL $65, YRCW $20

On 12/21/2007: CC $5, JBL $15, JBL $17.5, SKY $30, URI $25, URI $30

On 1/18/2008: ACO $30, CEG $100, DNEX $75, FNM $32.5, FNM $35, HIG $80, PFG $60, PFG $65, S $10,
S $11, S $12, SYK $70, VARI $65,

On 2/15/2008: ARRS $7.5, GVA $32.5, GVA $35, VMI $85

On 4/18/2008: ACO $30, ICUI $25, ISRG $290, ISRG $300, ISRG $310, ISRG $320, ISRG $330, ISRG
$340, USTR $50

On 5/16/2008: FBC $5, ICE $155

On 6/20/2008: CME $430, FCX $120, GOOG $550, GOOG $560, MLM $110

On 7/18/2008: AAPL $170, GAP $20, GAP $22.5, GILD $50, GILD $52.5, GILD $55, GOOG $490, GOOG
$500, GOOG $510, GOOG $520, GOOG $530, MAN $55

On 8/15/2008: CF $130, HAR $40, MENT $12.5, PVA $65

This very incomplete list shows that it is not at all uncommon for a short put to get into trouble on or
near expiration.

The bottom line is that short put is very much a high-maintenance creature compared to an equivalent
covered call. It is preferable to trade the short puts only in accounts with reasonable shorting privileges,
even if the puts are cash-secured.

Aside from the risk-management differences, the covered call and the “naked” put are interchangeable
strategies. Success of either depends on whether the writer’s neutral-to-bullish view of the underlying has
been accurate. The risk mitigation philosophy for either strategy boils down to the question – how much
unrealized loss you are going to tolerate while holding the underlying stock long term.

I prefer to execute one of the many exit strategies available to us like rolling down or closing the
short call position and selling the stock.

The best approach is to educate yourself before involking this strategy, paper trading and then
designing a well-thought out plan. Do this and success is inevitable.