Thursday, January 5, 2012

Covered Calls - The Naked Truth

Seeing as I have kicked off this blog by following a hypothetical portfolio of covered calls, I thought I'd have a bit of fun with a thought exercise. This is something every option professional knows, but many option noobies have a bit of trouble with.

We all know what a covered call is, long the stock and short calls in equal proportion. For example, if we Own or buy 100 of XYZ stock, we write 1 call contract.

Covered calls are variously promoted as a conservative option strategy, almost risk-less, easy monthly income and a host of other soothing adjectives and superlatives.

On the other hand, naked short puts are often castigated as being highly risky, having unlimited risk, dangerous, gambling and perhaps even having the potential to give you heart disease and herpes.

The overarching message is covered calls - good, naked puts - bad. Most covered call traders are quite comfortable with the strategy... initially at least. These same traders probably reach for their crucifix and don a string of garlic immediately naked puts are mentioned.

Unless you are au fait with option synthetics, you might be wondering why I'm talking about this.

It's because a covered call IS a naked put. Or more accurately, a covered call is a synthetic naked put. They have the same risks, same reward, same payoff diagram. If you are trading covered calls, you are ipso facto trading naked puts.

The only caveat to that is that the the strikes and expiry must be corresponding. So if you have a covered call with a $95 strike and March 2012 expiry, you in fact have a naked short march 2012 $95 put.

Need proof? I'll go through the maths in a later post.

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