December 8, 2005

The Covered Put
by John Brasher, CallWriter Publisher

Every now and then I get asked about writing covered puts in down markets. Many assume that it is essentially a covered call in reverse, and there is some truth to that. But just as a covered call is a synthetic naked put, the covered put is a synthetic naked call. And naked calls - in any form - pose some serious risks.

The Covered Put - How it is Made The covered call is fairly well understood by traders: buy shares of stock and write (sell) call options against those shares. The calls you sell may be exercised, meaning that you will have to deliver the underlying shares of stock at the calls' exercise price. Your delivery obligation is covered, which is why they are referred to as covered calls. The covered put is done in reverse, sort of a Bizarro world double to the covered call. The covered put is created by selling shares of a stock short and writing put options against the short position created. Like the covered call, the covered put is designed to produce premium income from the sale of puts. If the stock in fact declines enough, the underlying shares will be put to the covered put writer, who will use the shares to fill the short position. The Covered Put and Covered Call Compared   Covered Call Covered Put   Buy shares of stock Short-sell stock   Sell call options on shares Sell put options on short position         Trade Orientation Trade Orientation   Neutral to bullish Neutral to Bearish   Purpose is to produce income Purpose is to produce income The covered put wins and loses much like a covered call, only in reverse. Just as the covered call writer hopes the stock will hold its price or advance, the covered put writer hopes for the stock to decline, or at least hold price. However, the carrying costs of the trades are very different, as are the risks. Covered Put Risks and Costs Instead of buying the stock, the covered put writer shorts the stock, which almost always involves borrowing the stock. (The exception would be the situation where the trader actually owns the underlying stock and sells short "against the box.") When stock is sold short, interest must be paid on the stock loan to the stock owner. In addition, the short trader must pay over to the stock owner all dividends received while the short position is open. Naturally, the broker will want unencumbered cash or securities in the account at least equal to the amount of the stock price. But since the covered put position essentially is a naked call synthetically created, the broker will want a substantial account value of at least $75,000, and perhaps more, as is the case with naked calls. That is a lot of trade cost and risk just to pocket the prermium. And put premiums generally are not as fat as call premiums, all things being equal. For the non-professional trader, the naked call looks like a better trade than the covered put all around. By comparison, the covered call writer buys the underlying stock, and the maximum risk incurred is the net debit paid for the stock. Risk-wise, the worst that can happen is that the stock goes to zero for a total loss of the net debit amount. This is a fairly rare occurrence. There is an opportunity cost to running a covered call trade, of course; the cash tied up in the stock cannot be used for another trade. But this is true in regard to any trade. While I have never chosen covered call trades trying to pick up a dividend (I'm a short-term trader, and the dividend is priced into the stock once it is announced), the fact is that the covered call writer receives dividends on the stock. Alternative Strategies to the Covered Put The covered put therefore makes no sense to me in light of the carrying costs. To be honest, I've never run a covered put trade, and don't intend to. To play a dropping stock or a stock on which I am bearish, I would use a different strategy, such as: bear put spread (buy a put, sell a lower-priced put) bear call spread (sell an OTM call, buy a higher-priced call) naked call (the call premium is like free money if you're a good chart analyst) synthetic short stock (sell a call naked and buy the put; short call pays for the put) buy a put (you only risk the premium paid)) All these strategies work like gangbusters if you've got the stock direction and the timing of the move right. Come to think of it, that's true in every trade. Actually, a dropping stock can work just fine in a covered call trade, provided the call strike is deeply in the money and the time value in the call premium makes the trade worthwhile. This goes against the advice of learned option gurus, I know, and I apologize for sounding radical - it just happens to work when done right. More on that another day... This issue's Question and Answer: Covered Put versus Naked Put Question: I have heard that a covered put is safer than a cash-secured naked put. Agree or disagree? Answer:   Disagree. They are very different trades, used for different purposes. As noted above, a covered put is a combination trade that involves selling shares of stock short and writing a put against the short position, which should only be done in a flat or, preferably, declining market. Because a covered put is a synthetic way of creating a naked call, it involves a theoretically unlimited risk if the stock moves up. And for the reasons discussed above, the covered put is a relatively expensive trade to put on. A cash-secured put is a sale of naked puts that does not involve shorting the stock. The put writer instead secures the put (really, secures the broker) by having cash or other value in the account equal to the value of the underlying stock up to the put’s strike price, less put premium received. The naked put (which has the same risk/reward profile as a covered call) is put on when the trader is neutral to bullish on the underlying stock. The naked put writer's risk is that the stock price falls, in which event the stock would be put to the writer if in the money at expiration (maybe even earlier). In assessing risk, one must assess and weigh the practical risk against the maximum theoretical risk. Because the maximum risk to the naked put writer is the amount of the put's strike, the total amount at risk is known, however large it may be. Sure, Google or Microsoft could pull back, hurting naked put positions, but does anyone really expect either stockto go to zero, wiping out naked put positions? The risk to the covered put writer, on the other hand, could be much greater, since it is both unknown and unlimited. By example, I watched OSI Pharmaceuticals go from $38 to $96 overnight, which decimated naked call positions; and there are plenty of other like examples. Stock prices can explode, however theoretical we consider the probability to be.

Good luck and good trading!