Educational Strategy Reprints

Writing Puts: An Alternative to Covered Call Writing

When you write a put on a particular stock with a certain strike and expiration, you have a position that has very similar gain and loss potential as a covered call on that same stock with the same strike and expiration. In this report, we show an example in which the put write combined with cash would be less risky and better profit potential than a covered call on the same stock with the same strike and expiration. Lastly, we will discuss different ways to control the risk of writing puts.

Two Equivalent Positions

When you write a "naked" put or write a covered call, you are really selling time premium in return for limited gains on the upside and unlimited exposure on the downside. Usually, for calls and puts of the same strike and expiration, this time premium, net of interest and dividends, is extremely close.

There is a theoretical as well as a practical reason for these time premiums being so close. The theoretical reason is that call and put premiums cover essentially the same risk (of the stock making a big move) regardless of whether you are bullish or bearish. The practical reason is that option market makers arbitrage between calls and puts, bringing the time premiums of the two into line. (See "Put/Call Parity and How to Use It," also in this series.)

Here is comparison of a recommended put write and its corresponding covered call.

In Table 1, we have selected the Biovail Corp. April $40 put write and covered call, both recommended on February 11, 2002 when the stock was at $42.50. The April $40 put was slightly out-of-the-money with a premium of $3.30. The April $40 was slightly in-the-money at $5.60. Notice that both positions have almost identical dollar payoffs at different stock prices at expiration. Also note that when we calculate the return of the naked put write, we factor in the interest on the cash balance that would be required to fully collateralize the put write at its strike price.

On the April expiration date, should the stock have fallen by 25% to $31.88, the covered call would lose $503, while the naked put would lose $465. If the stock ends up at or above the $40 strike price, the covered call will earn $310, while the naked put will earn $348.

In this example, the short put has the advantage over the covered call. Also, when choosing between the two strategies, you should factor in the commissions that you would need to pay to close out your short call at expiration (if the stock is above the strike). Here, you need to consider your own expectations. If you expect the stock to end up above the strike price, then the short put may be the preferable to the covered call. If you expect the stock to end up below the strike price then the covered call may be the way to go.

Looking for Opportunities

Because the net time premiums of calls and puts with the same stock, strike and expiration can be very close, it often happens that if we are recommending a particular call for covered writing, we are also recommending the corresponding put for "naked" put writing as well. On February 13th, 2002, we were recommending 341 covered calls and "naked" short puts that had the same stock, strike price and expiration.

Leverage and Diversification

Writing uncovered short puts can also allow the investor greater leverage and diversification. This is because you can write can write a greater number of puts using margin. At present the exchange minimum margin on a "naked" short option is the greater of: (1) 20% of the underlying minus the amount the stock is out-of-the-money; or, (2) 10% of the underlying. However, along with this leverage comes additional risk since one can lose many times the original margin if there is a big enough decline in the stock.

One way to help modify this risk is to buy index options to hedge a portfolio of "naked" put writes.

In Table 2, we have selected six recommended put writes for a total margin cost of $12,583 versus about $60,000 that it would take to establish the same positions as covered calls. In our example, we have been able to cover some of the risk of these positions by buying index options that will produce a partial offset if the market declines.

Note: another way to cover the risk of a short put is to buy a lower strike put as well. This creates a spread known as a bull put spread. (See "Credit Spreads as Naked Write Alternatives,' also in this series.)

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Prepared by Lawrence D. Cavanagh,
Editor, Value Line Options
vloptions@valueline.com