Many of our students, after following our step-by-step criteria before considering such a position, want to sell naked puts on stocks experiencing extremely high volatility. We are staunch proponents of risk averse trading, but there are times when selling naked puts make sense.
However, often brokers try to steer them away from the sale of a naked put because of risk considerations, and instead, try to get them to buy a covered call in its place. Huh? This is akin to saying, “Don’t buy six call contracts, buy a half dozen instead.” A covered call and the sale of a naked short put are one and the same.

Amazingly, many brokers have different risk levels that need to be approved before they will allow the use of a certain strategy. Often, the covered call is the first thing brokers will allow a client to trade because it is deemed safe. The sale of a naked put is the last thing that is approved since it is “ultra risky.” Again, huh?

If you are new to options, you understandably may not know the difference between a short put and a long covered call (long stock and short call). Even if you are a veteran to options trading, you may not know that the two are simply synthetics of one another. Do not be embarrassed if you didn’t know this. You can save a lot of money by asking simple questions and lose it by being silent when you don’t understand a potential trade.



We will use Apple, Inc. (AAPL) as a case study, but any stock or index would work exactly the same way. It does not matter how many days there are until expiration, or what the volatility of the underlying is because it will still work exactly the same way as the example being shown.

On March 5, Apple closed at $219. The price of the March 220 put was $4.75; the price of the 220 call was $3.75.

How does the sale of the 220 put differ from the purchase of 100 shares of stock combined with the sale of the 220 call (thus a covered call)? If the break-even graph at expiration differs from the profit and loss of the two positions at any time in any way, then the broker was correct. However, it is our contention that they are exactly the same. Let’s see who is right.

“Apples to apples” illustrates what each component in our comparison is trading for at expiration through a $100 range in the underlying stock price (you could plug in any number and the results will be the same). The fourth column in the table represents the value of the covered call (long stock/short call), while the fifth column represents the value of the put sale at expiration. Looking at the fourth and fifth columns (highlighted in yellow), you will notice that there is no difference between the covered call and the put sale regardless of share price.

The margin on the two positions should be the same, though arrived at from different points, and the covered call position requires two trades, so you will be paying extra commission.

Random Walk is not discouraging or encouraging the sale of a naked put or a covered call. The article is meant to demonstrate how they are the same position. To achieve long-term success, you should know what you are trading before you enter into a position.

If you are not scared of covered calls, you shouldn’t be scared of naked puts. And if an educational company or broker tells you never to sell a naked put or that the covered call is a safer strategy, then you know it is time to run.

Alex Mendoza is the chief options strategist with Random Walk, which has produced numerous articles, books and CDs on options trading, including a book on broken-wing butterfly spreads. Visit their Web site:  www.RandomWalkTrading.com

• • 5/9/2010 9:05:28 AM
  • bizcon
  • Buying Put and balance with Futures
  • Hi, I would like to know that in times like these, would it be better to buy Put at current market price of Index for Far Month and balance it with Futures? If yes, how to do it and whether to take position in Futures immediately on buying the Put? Thanks. Sharad
• • 5/26/2010 9:55:39 AM
  • Stephen Johnson
  • Naked Puts
  • In theory your comparison of naked puts and covered calls is correct, however reality is different. Usually more calls trade than puts making calls more liquid, resulting in tighter spreads. Puts are professional money managers' tools which time decay more slowly than calls because professionals roll their puts, portfolio insurance, at the last minute,to the next month. The market falls much faster than it gains making large losses in naked puts more likely. The recent "flash crash" saw market makers walking away rather than making markets, further strenghening my case as why not to short puts naked. In floor terms, "You eat like a hummingbird and crap like an elephant".
• • 6/25/2010 1:59:17 PM
  • Alex Mendoza
  • How Is That Different?
  • Let's take the points one by one: 1) Calls trade more than puts and are hence more liquid Response: Given the commonplace use of synthetic positions, any significant liquidity difference will have been eroded away as traders will simply gravitate toward the path of least resistance. 2) Puts decay more slowly than calls Response: If they did, then we would all buy puts, sell calls, maybe buy stock as a hedge, and keep the difference in time decay. This position is called a conversion and is not theta positive by definition. 3) The market falls much faster than it gains making large losses in naked puts more likely. Response: Markets crash because stocks drop. Given that the largest component of a covered call position is... stock... it would stand to reason that the covered call would not be immune to the losses suffered by naked puts. 4) In the flash crash, market makers walked away rather than making markets Response: This may be true, but if they walk away, then there are less markets made on both calls and puts. Please let me know if you would like these points explained in further detail and I will be more than happy to oblige. In this particular case, the theory and the practice actually mesh together quite nicely. Kind regards.
• • 1/5/2011 9:14:59 PM
  • oddsneds
  • naked puts vs covered calls
  • I have used both strategies for several years now but this is the first time I've had the two explained as equal, and it is like a light being turned on. Thanks for the explanation. My online broker, Fidelity, put me through the third degree to get approved for naked puts, and in one of my accounts (Simple IRA set up through my employer) they refuse to allow them at all! I tend to use covered calls on existing stock positions to either protect gains or add"income" on a dull position, and sell naked puts to get the desired return up front on stocks I am willing to own at the lower price. Thanks again.
• • 3/16/2011 6:56:29 AM
  • QuickQuestion
  • Dividends & American Options
  • In principal I agree that covered call = short put. However, there are two things that could make a small difference: 1) you don't collect the dividends with short put; 2) when share price rises does your holding gets called away??? (with american options) crystallizing your max profit, while your short put would stay in place and subsequent share price fall could cause loss for the naked put? Any thoughts? Thanks

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