Covered Calls and Naked Puts

Double Discount Your Stock Purchases with Covered Calls and Naked Puts

Some have asked whether a covered calls and naked puts combination is an options trading strategy worth considering. The best way to answer that is, that it depends on how you choose to do it.

There is a profitable, low-risk way which we have covered on the page entitled “Using Options to Buy Stocks“. The basic idea outlined there, is that when you believe that a stock is due for a reversal from its present downward price movement, possibly because it is not far from a strong price support area (another subject in itself – the realm of technical analysis) or it might be because you are bottom fishing stocks you sell naked put options at the strike price at which you are prepared to purchase the stock.

In return, you will receive a credit to your account for the option premium. You effectively get paid to wait for the price to fall to your preferred purchase level.

If the price of the underlying continues to fall to the anticipated support level, you will most likely be exercised and the underlying shares, commodity futures, or whatever, will be yours. You then immediately sell call options at a strike price above your purchase price for further income.

If the underlying never falls to the anticipated price level, however, you simply keep the put option premium at the expiration date.

Using this covered calls and naked puts strategy, you not only receive an income but this double income from naked puts followed by covered calls offsets your overall cost of holding the shares once they are assigned to you.

With some imagination, instead of just selling naked puts, to begin with, you could also protect yourself by entering a put credit spread at the price level you are prepared to own the stocks. The way-out-of-the-money bought put would cost you a relatively insignificant sum but also provide some protection should the underlying price fall sharply.

For more information, including worked examples, we refer you to Using Options to Buy Stocks at a Discount.

Covered Calls and Naked Puts – Same Risk Graph

Another way to look at covered calls and naked puts is by viewing them as two separate and independent option trading strategies. If you have access to some software that provides risk graphs, you will find that the covered calls risk graph looks exactly the same as the naked put risk graph.

In other words, if you purchased stocks and then wrote call options above them, then analyzed the risk graph, you would find limited upside profit potential and unlimited downside loss potential should the underlying stock price crash big time.

Now you do the same thing, only with a “naked put” strategy. By simply selling put options “naked” and then viewing the risk graph, you will find exactly the same result – limited profit (the premium received) and unlimited loss should the stock continue to fall. This is one reason why “bottom-fishing” is a relatively safe approach.

Our conclusion therefore is, that the standard buy/write or covered call strategy when used alone, is not as effective as this one, if you are looking for regular income. The only advantage of covered calls over naked puts is that you get to keep the shares until the price recovers (if it does).

There are, however, more advanced covered call strategies which are outlined elsewhere on this site, designed to minimize your risk and change the graph.

Using it as a Range Trading Strategy

There is also a less desirable, more risky, way to employ the covered calls and naked puts trade.

Let’s explore another possible covered call and naked puts scenario.

Imagine a company, let’s call it XYZ, is currently trading at $20 and you believe it is due for a rise in the next month or so. So you do the following:

1. Purchase XYZ at $20
2. Sell $22.50 XYZ call options with expiration next month out and receive $1.50 premium
[this part is your normal covered call]

3. Simultaneously sell (short) $17.50 put options and receive a further premium of $1.50. You would need enough collateral in your brokerage account to cover the additional purchase of the equivalent number of XYZ shares in your option contract at $17.50 each.

 

Analysis of Covered Calls and Naked Puts position:

You have now taken in $3 in options premium to offset the cost of your $20 purchase price on XYZ shares, bringing their effective cost down to $17 per share.

You are also now obligated to sell these shares at a maximum price of $22.50 should the market price rise above that amount.

You are also obligated to purchase a second lot of shares at $17.50 should the market price of the stock fall below that level.

As long as the stock price remains somewhere between $17.50 and $22.50 at the option expiration date, you get to keep all the premium you have taken in and since $3 is more than the maximum $2.50 loss on the shares, you make an overall profit as well.

But say XYZ stock becomes volatile and the price moves sharply either way? The bottom line is, that if it goes north, you make even more profit, but if it tanks below $17 you could be in trouble.

Here’s why.

Imagine the stock price rises sharply and at the option expiration date, is trading at $25. At this price, your call options will likely be exercised and you will be forced to sell your shares for $22.50 – but here you make a further $2.50 profit on the stock, and all positions are closed, leaving you with a total profit of $3 option premium plus $2.50 from the stock = $5.50 per share total profit. Nice!

But if XYZ plummets to $15 what are we looking at then? It’s times like this that we are faced with the stark reality of what “naked’ really means when it comes to selling options.

At $15 market price, your account would look like this:

1. There would be a $5 capital loss on your XYZ shares
2. You would also be forced to purchase a FURTHER lot of XYZ shares for $17.50 when you could buy them on the open market for only $15 – a $2.50 theoretical loss on purchase (you never actually realize a loss until you sell the shares)
3. Your position is now down $5 plus $2.50 = $7.50 per share.
4. But this is offset by the $3 option premiums you took in from shorting the calls and puts.

So your overall net loss at expiration date is $7.50 less $3 = $4.50 per share.

Covered Calls and Naked Puts Breakeven

Your breakeven level at expiration date is $17.25
($2.75 loss $20 shares + 25 cents loss on $17.50 shares – $3 option premiums received).

Below this level, you start to make a loss.

At the breakeven point you could offset any further losses by buying back the ‘sold’ now way-OTM $22.50 call option for a few cents and then sell a $20 call option for another $1.50 premium – say an overall gain of $1.25. Or if you want to go a further month out you might get around $2 per share.

You could also choose at this point to ‘cover’ your naked put by now purchasing (going long) an ‘out-of-the-money’ put, say at $15 strike price, for about $1.25 (depending on how many days to expiry now). It would not prevent further losses on the shares you already own should the price fall further. But it would limit losses on the additional shares you would have to purchase, to $2.50 per share, if your short puts were exercised.

You now have received $3 from your original options to offset losses on your original shares, plus a further potential maximum loss of $2.50 per share on any additional shares you might have to purchase at $17.50. At the expiration date, you now have a potential maximum profit should the stock turn around, of $5.50 per share, unlimited losses on your original shares plus a further $2.50 maximum loss on your $17.50 shares.

So to summarize, you could say that a covered call and naked put option trading strategy is to some extent a range trading strategy. If the stock breaks out on the upside, you’re looking good and don’t care how far it goes as you still make a good profit. But if it breaks to the downside, your exposed all the way to a maximum potential of zero stock price. But remember, on purchased shares, you only ever realize a loss when you sell them. You could choose to hold until they return to a better level, but do you want to tie up your capital for that long?