Question

Explain he differences between trading Naked call and puts and Covered calls and puts, why does this matter and what differences does it mean in margin management and risk management? Be specific and detailed.

Answer 1

The answer is as below:

Investors beginning to use options will frequently start with covered calls. This options strategy provides the benefits of reduced portfolio volatility, monthly income and increased risk control, according to the latest options trading information.Depending on our options this may be the only options strategy authorized for a new account.

The benefits of covered calls are significant, and over the long term can increase portfolio returns. However, it may surprise many investors that the same benefits can be had without increasing risk by selling short or naked puts.

In fact, selling naked puts against the S&P 500 (NYSE: SPX) has been shown to outperform the returns of the S&P 500 alone, or a covered call strategy on the S&P 500 over the long term.

Which is Riskier: Covered Calls or Naked Puts?

Investors will often avoid naked options trading because they believe that the strategy exposes them to unlimited risk, which is theoretically true with a short call, but is not the case with a short put.

In fact, the maximum risk in a short put is equal to the price of the stock minus the premium received. That is the same risk we are exposed to in a covered call.

The following is an example :This may seem strange, but consider that when we sell a covered call we own the stock. If that stock is worth $50 a share and falls to zero, then we have lost $50 minus the premium of the call.

Conversely, if we sold naked puts and the same stock falls to zero, then we will have the option exercised for $50, which (minus the premium for the put we sold) is our maximum risk. It is surprising that these two strategies that seem so different could be so similar from a risk perspective.

Which Options Strategy is Right for us?

Often what we are trying to do with a covered call is to increase our control over the downside potential of a stock that we own. If we are very concerned about the near term we may sell a call that is at or slightly in the money. Conversely, if we are very optimistic in the near term, we may sell a call that is out of the money for a smaller premium but more upside potential.

A short, or naked puts, can be used in the same way by selling in or out of the money depending on how bullish or bearish we feel.

While many things are similar between the two strategies, one of the advantages of a short put is that the costs are lower. A short put is only one transaction while a buy-write or covered call is two.

Additionally, although a short put’s upside potential is limited to the premium alone, it usually has more downside protection than a covered call.

Although both strategies are bullish, we would normally anticipate that a strategy with naked puts will outperform covered calls in a volatile or downtrending market.

Which strategy is right for us depends on our trading objectives and market outlook. If we need maximum control over our risk, then a strategy using naked puts may be the best choice.

If we want more upside potential and are willing to take on more risk, out-of-the-money covered calls are appropriate. This is of one of the best things that an options trader will have many alternatives and a lot of flexibility to make the right choice for your portfolio.