I have a lot of non-investing stuff going on this week with my family and won’t be trading at all. Knowing that, I wrote this post last week since I knew I wouldn’t be able to get any other posts written. This is also why I didn’t get an index chart posted over the weekend.
I recently noticed something interesting about how I’ve been investing and it’s making me rethink my options investing approach. For years my approach has been to target the majority of my trades to be out of the money naked puts as an entry into a stock or a simple collection of the option premiums. Once I own the stock I tend to sell out of the money covered calls. The odd part of this approach is that the risk (both upside and downside) are the same with naked puts and covered calls. Since that’s the case I’m starting to wonder why I decide to sell out of the money (OTM) on both.
With OTM naked puts I’m giving myself more cushion to the downside, but less upside potential than with OTM covered calls. I like the downside reduced risk I accept with the OTM naked puts and am starting to wonder if the decision to go OTM with the covered calls is an emotional decision in my effort to not lose on the underlying stocks once assigned the shares. That’s probably part of it, but sometimes I do sell the covered calls at strikes low enough to cause a loss on the shares. I think it’s a difference of fearing the loss of opportunity once I own the shares. It’s kind of like I’d be more disappointed by selling at $50 and then seeing the stock go to $55 than if I sold at $50 and saw the stock go to $45. Either way it’s a loss of $5 over what I could’ve had if I didn’t sell.
I’m not sure if I’ll change my investing model at all, but I will start thinking harder on some of these covered call moves. Sometimes I sell OTM because the stock was assigned to me and is still sitting near an area I consider support. In those cases I’ll continue to sell OTM. The other side to think about I’ve started changing some already. That’s on the first trade, the original naked put. Instead of going OTM on the naked puts, I’ve sold half a position at the money. The premium intake is greater, the total dollar risk is lower, but the probability of an assignment is higher. What I like the most about starting with a half order is getting assigned the stock and then writing another naked put at a lower strike and a covered call OTM. It gives me the opportunity to double up on the premiums and somewhat dollar cost average into a new position. The downside to this is in a bull market where I don’t sell enough options to keep up with the market’s returns. That might be a risk worth accepting if I’m thinking longer term.
What do y’all think? Am I on to something here? Is this just common sense and you’re surprised I didn’t notice this earlier?
From an investing perspective I don’t think what you describe sounds strange at all. When you’re put a stock, presumably it’s at what you’d consider a good value with upside potential. So immediately selling at-the-money calls against it – and significantly capping any potential upside gains – would seem to be a bit at odds with the reasoning behind the original put sale.
On the other hand, if this is strictly being used as a trading strategy, then that’s another story. In that case, I’d agree that there are certainly better ways to control/minimize risk than selling OTM covered calls.
I tend to approach things from an investing perspective, so I’ll often end up waiting quite a while before selling covered calls against a stock I’m long (depending on whether it’s a core holding, its valuation, its price action and that of the overall market, and option volatility/availability). In the meantime, since I focus mostly on dividend-paying stocks, I’m usually getting paid to wait.
R Pell, you nailed my logic. It’s all about sticking with the original expectation of technical support holding and fundamentals staying sound.
>> The odd part of this approach is that the risk (both upside and downside) are the same with
>> naked puts and covered calls.
Actually, cash-secured puts, not naked puts — a naked put doesn’t need the capital investment to secure it, which a covered call would.
In any case, keep in mind that CSP and CC are about equivalent AT THE SAME STRIKE PRICE. So that would mean an ITM CC is about the same as an OTM CSP, and an OTM CC would be about the same as an ITM CSP.
So you really are doing two different strategies.
I usually go ATM to maximize the extrinsic value.
>> Actually, cash-secured puts, not naked puts — a naked put doesn’t need
>> the capital investment to secure it, which a covered call would.
Technically speaking, I think any short put position that doesn’t also include being short the underlying stock is considered a “naked” position, which would include both cash secured and non-cash-secured short put positions.
The definition of an “uncovered” or “naked” put from the CBOE website:
“A short put option position in which the writer does not have a corresponding short position in the underlying security or has not deposited, in a cash account, cash or cash equivalents equal to the exercise value of the put.”
I’ve always thought of naked puts as R Pell describes it, but I guess it’s hard to argue with the CBOE. It’s still hard to argue that if you have a mixture of covered calls and puts that exceeds the total cash/capital available which ones are cash secured and which are potential naked puts. Randy, you are saying what I was trying to say, if I use the same strike price the risk/reward is the same. What I was rethinking in my own strategy was why do I sell OTM for both. I should be more consistant with my risk maybe, but R Pell understood my logic that when I sell OTM CCs I’m expecting my original plan of the underlying stocks’ support to continue to work. I don’t keep these rules set in stone as you’ll notice from my Friday (6/18) ATM covered call sell on GES, $10 below my put strike I opened the position with.
(I’ll still continue to refer to my puts as “naked” since some do switch to non-cash secured and trying to time my wording for the swaying of my positions doesn’t sound appealing. Either way, a put is a put and if you sell wrong you lose.)
>> The definition of an “uncovered” or “naked” put from the CBOE website:
Interestingly, the same source doesn’t make any distinction when defining the more general term “uncovered” (or “naked”) option:
“Uncovered Option – A written option is considered to be uncovered if the investor does not have an offsetting position in the underlying security.”
It’s a fair point, though, to make a distinction between “naked” and “cash secured” puts. But to Alex’s point, “naked” could still refer to any short put position that is up to 99.9% backed by available cash.
>> which ones are cash secured and which are potential naked puts.
If a put is truly “cash secured”, I don’t think there is any possibility of confusion. The cash used to secure it is unavailable for other purposes and designated as security for a specific put.
Sounds like you are thinking more of a margin account situation. I do my option trading in an IRA account — so all shorting has to be completely covered.
>> Interestingly, the same source doesn’t make any distinction when defining the more
>> general term “uncovered” (or “naked”) option
Correct — if you look up “naked” in their dictionary, it says: “see uncovered”. So they see them as identical.
Ah, 8 comments later we get to the point of confusion. Randy, this account I blog about is a margin account. In fact right now if all of my puts were assigned I’d be on margin.
If you’re securing the puts with margin instead of cash, then the short put position really is not equivalent to a covered call. Granted, you may have the same amount of capital at risk, but you don’t have to put it up before shorting the put. That CAN make the short put riskier than the covered call, simply because you can short on more shares of the underlying by using margin.
Sounds like you’re actually in that position, if you would be on margin if they were all assigned.
If I have $60k in covered calls and $60k in naked puts and only $100k to back it all I’m not actually on margin yet, but I look at the potential as $20k of possible margin. In such a case I don’t draw a distinction of which underlying dollars go with which position to qualify any put as a CSP vs naked. If I didn’t want to have potential margin I’d have to close either the puts or covered calls. If all $60k puts are then assigned I’d have $120k invested backed by $100k. If I turned those into covered calls the risk is exactly the same as a naked put, agree? Any further puts would be naked for sure, but the risk/reward would be the same for those as the covered calls. If one underlying company went bankrupt from either a naked put or a covered call I’d still lose 100% below the strike minus the premium.
FYI, I won’t let myself sell more than 2x the amount of cash I have to back my puts, but haven’t even been more than 1.5x in well over a year. I’m about 1.25x right now (6/21).