Covered Calls versus Naked Puts

Covered call writing is a low risk option strategy. If the underlying rises above the strike price the calls are assigned, you deliver the shares and exit with the best case scenario.

Covered calls make money in a rising or flat market and because the premium received reduces the cost of the underlying shares, is less risky than an outright long position in the stock.

Maximum return is at the strike price of the call, maximum risk occurs if the underlying declines to zero. Although to be fair, maximum risk is a function of the underlying security not the strategy.

Now look at naked put writing. Characterizing any strategy as “naked” implies risk. One is not “covered” by a long position in the underlying but rather is taking on a commitment to buy shares at a specific price for a pre-determined time period.

But here’s the rub; If the naked put writer secures the obligation with cash (i.e. cash secured put) is the strategy riskier than covered calls? Maximum return occurs at the strike price, maximum risk if the underlying decline to zero. In short – pardon the pun – covered calls and cash secured puts are equivalent positions.

So what leads an investor to employ one position and not the other? One reason is the regulatory environment which does not allow the sale of puts inside registered plans (i.e. RRSPs, RRIFs, RESPs, TFSAs). Simply stated the inherent obligation to buy whether secured with cash or not, requires margin. Registered plans are not marginable.

You have to be approved for a higher level of option trading when executing naked option positions. And there are good reasons for that! Put writers tend to leverage their exposure to an underlying security. Cash secured positions are not set in stone because you can always tap the cash being used to secure the position. Very different from the covered call writer who would have to sell shares in order to raise cash.

On the positive side a cash secured put can be executed with a single trade… one commission, one bid ask spread. That can be useful if you need to exit a losing position.

It can also benefit when trading positions on foreign markets. If you buy a dividend paying US stock you are subjected to withholding tax on the dividends and foreign exchange risk on the entire position.

If you write a put to buy a US stock and secure it with case held in Canada, you eliminate most of the foreign currency risk. Also the put premium takes into account any dividends payable by the underlying security.

Once a short put position is established be mindful of certain twists like the erosion of time value. Typically, time value for in-the-money puts erodes more rapidly than for in-the-money call options. And while that can be an advantage the rapid erosion of time value on in-the-money puts increases the likelihood that the puts will be assigned early. That happens more often than not particularly if a dividend payment is imminent.

So despite the fact that covered calls and naked puts are equivalent positions it is important to understand the subtleties associated with each strategy.