OC
You make valid points in that an OTM naked put might be the better trade. But it is not the equivalent trade. Sometimes it might be quite similar, but not equivalent. Similar means slightly (or hugely) different risk profiles. Equivalent means identical risk profiles.
PayS,
In your example you spoke of owning a $50 stock and selling the 55 call for $2.50. Max gain on this position is underlying >$55 at expiration. Let's assume at expiry the underlying is at $55. You get the $5 increase in stock price, and you keep the $2.50 premium on the calls. This position makes $750.
On the other hand, let's say you sold the 55 strike put for $7.50 instead. At expiry if the underlying is at $55 you will get to keep the entire $750. So you see the max profit is exactly the same.
Now let's say that the underlying dropped to $47.5 at expiration like you said.
Your stock will have lost $250 because you owned 100 shares, but you made $250 on the calls you sold against it. So as you stated you are at break even at 47.5
What if you sold the 55 puts instead? You are $7.50 ITM at expiration, so that would be your loss. But you collected $7.50 in premium for each option. So again you made $750 and lost $750. You are at break even.
You can run the analysis with whatever expiration price you want and the result will be the same. The two positions are identical.
That is true except when it comes to leverage. You were wondering about my numbers.
$750 return (less $5 commiss) on a $2,375 investment is about 31.4% return. Assuming you scaled the position each time there were gains and you could do the position 8 times a year, you'd have a return of 787%. In other words a $100K investment would be worth $887K after one year. Assuming max profit each time you closed the position.
OTOH, the naked put portfolio numbers:
$750 return (less $0.75 commiss) on $800 investment is about 93.7% return. The other $1,575 you didn't tie up in the position can be invested in fixed income. We assumed a 5% return or a 0.625% return each period. Assuming you scaled the position and performed 8 times, the annual return would be 820%. Your $100K account is now worth $920K.
That is a difference of $33K which is only 4% of the yearly gains (33K/820K) but when you compare it to the initial port size, that is an extra 33% return. Show me an investor that doesn't care if you throw away an extra 33% gain each year that was otherwise free money.
As OC said, many brokers will allow you to hold fixed income investments against your naked puts. There is really only one reason to do the covered call instead of selling the put. If the account is an IRA account then it is actually prohibited from the naked put. Some people think the regulators don't realize the equivalence of the two positions. Personally I think they are trying to force people to actually take possession of the stock to keep the market progressing.
You make valid points in that an OTM naked put might be the better trade. But it is not the equivalent trade. Sometimes it might be quite similar, but not equivalent. Similar means slightly (or hugely) different risk profiles. Equivalent means identical risk profiles.
PayS,
In your example you spoke of owning a $50 stock and selling the 55 call for $2.50. Max gain on this position is underlying >$55 at expiration. Let's assume at expiry the underlying is at $55. You get the $5 increase in stock price, and you keep the $2.50 premium on the calls. This position makes $750.
On the other hand, let's say you sold the 55 strike put for $7.50 instead. At expiry if the underlying is at $55 you will get to keep the entire $750. So you see the max profit is exactly the same.
Now let's say that the underlying dropped to $47.5 at expiration like you said.
Your stock will have lost $250 because you owned 100 shares, but you made $250 on the calls you sold against it. So as you stated you are at break even at 47.5
What if you sold the 55 puts instead? You are $7.50 ITM at expiration, so that would be your loss. But you collected $7.50 in premium for each option. So again you made $750 and lost $750. You are at break even.
You can run the analysis with whatever expiration price you want and the result will be the same. The two positions are identical.
That is true except when it comes to leverage. You were wondering about my numbers.
$750 return (less $5 commiss) on a $2,375 investment is about 31.4% return. Assuming you scaled the position each time there were gains and you could do the position 8 times a year, you'd have a return of 787%. In other words a $100K investment would be worth $887K after one year. Assuming max profit each time you closed the position.
OTOH, the naked put portfolio numbers:
$750 return (less $0.75 commiss) on $800 investment is about 93.7% return. The other $1,575 you didn't tie up in the position can be invested in fixed income. We assumed a 5% return or a 0.625% return each period. Assuming you scaled the position and performed 8 times, the annual return would be 820%. Your $100K account is now worth $920K.
That is a difference of $33K which is only 4% of the yearly gains (33K/820K) but when you compare it to the initial port size, that is an extra 33% return. Show me an investor that doesn't care if you throw away an extra 33% gain each year that was otherwise free money.
As OC said, many brokers will allow you to hold fixed income investments against your naked puts. There is really only one reason to do the covered call instead of selling the put. If the account is an IRA account then it is actually prohibited from the naked put. Some people think the regulators don't realize the equivalence of the two positions. Personally I think they are trying to force people to actually take possession of the stock to keep the market progressing.
. Not disagreeing with your points