Covered Call v/s Short Put ?

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Many stock investors start in options with covered calls strategy. This options strategy is also sold by many trainers as “collecting rent on your stock portfolio” and generating regular monthly income. But what you rarely find is someone telling you that it is same as selling Naked Put option, with no protection.

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 puts against the index has been shown to outperform the returns of the index alone, or a covered call strategy on the index 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 you are exposed to in a covered call.

For example – You have sold Naked put when nifty is at 5400 and collected 100 of premium. This gives you protection till nifty level of 5300 and below that, it is unlimited risk. Similarly, if you own reliance stock at 800, and sell a 900 strike Call to create covered call position. Say you got 50 Rs as premium. As long as stock is not traded below 750, your loss in stock position is protected. But below 750, you are still carrying the unlimited risk till stock going down to 0 level.

Hence these two strategies that seem so different could be so similar from a risk perspective.

Which Strategy is Right for You?

You sell covered call to partially protect against the downside. A short or naked put can be used in the same way by selling in or out of the money depending on how bullish or bearish you feel.

Looking at it from cost’s of transaction perspective, 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, you would normally anticipate that a short put strategy will outperform covered calls in a volatile or downtrending market.

Which strategy is right for you depends on your trading objectives and market outlook. If you need maximum control over your risk, then a short put strategy may be the best choice.

If you want more upside potential and are willing to take on more risk, out-of-the-money covered calls are appropriate.

To manage the risk of Short Put position, you can always buy farther OTM PUT and convert it into credit spread, or credit ratio spread.

Happy Trading

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9 Comments on “Covered Call v/s Short Put ?”

  • Alpesh
    31 July, 2012, 15:50

    It is my observation that we can protect sold put by sold call
    (Suppose Nifty at 5000 then we can sell 4800 put and 5200 call so protection will be around upto 400 rupees)
    Is any one agree with this pls letme know?

  • Trader anup
    31 July, 2012, 16:19

    No Alpesh. In my view, Protection / Hedging is correctly done when any kind of obligation is nullified by some type of rights or ownership.  It is a risk management approach to effectively reduce the risk. If you take another obligation to reduce the impact of previous obligation, then you will be adding on to your risk.  
    Assume the case, when you have short put and short call position, market drops vertically and broker squares-off your short put position due to margin call (and you are hit by a big loss). Next day, market bounces back strongly and your account, which is smaller in size due to previous loss, gets into another margin call on remaining open short call position.
    And broker squares-off your position once again and you are hit by one more big loss.
    I agreed that this might not happen frequently, but just one such event is enough to blow your profitable trading of few years. I know traders who have were consistently collecting money with short put strategy in bull market, but when market changed the direction in 2008 and volatility skyrocketed, they lost 2 years of earning in Sept/Oct 2008.
    So to summarise, I wouldn’t recommend protecting one short position with another short position. By the way, this argument is not valid with 2 long position cause with Longs, you are not doubling  your obligation.

  • Alpesh
    1 August, 2012, 7:17

    Yes Anup
    Thanks for sharing
    But I want to notify u that u have consider worst scenerio. Trading should be done with stoploss. In your example market droped and broker squre off your put but at the same time there is price loss for the call option you have short and u can square of call to cover the loss in some extent.

    I am not master of option but trying to study logically and has observation that shorting call and put is profitable in rangebound marcket with specific stoploss. (With respect to buying Call and Put simulteniously or buiying anyone)
    Pls let me know i am wrong I am wrong.

  • Trader anup
    1 August, 2012, 8:49

    I agreed Alpesh that I was talking about worst case scenario. But they do occur. Point I am highlighting is that 1 such event is sufficient to ruin your account, and that will have huge impact on your trading psychology for future trades. To me, Trading is about risk management and options give you that choice where you can pre-define your risk, irrespective of any event in the world.  I normal rangebound market conditions, Short Strangle (short call+short put) has very good success rate. But that has to traded under the umbrella of 1) identifying range bound market on right most bar of the chart  2) Very Strong position management and risk management discipline 3) traders agility to be realistic about change in market direction and react quickly.

    Don’t get me wrong that I am against short strangles. I do use them when market is appropriate. It is just that I don’t want people to ignore the dark side of such high risk strategy. 

    Regarding your point on stoploss – Stoploss gets triggered when your trigger price is traded at the exchange. If you are overnight position traders and trade in non-24hrs market open, stoploss are not guaranteed. Such 3 standard deviation events may happen overnight, and market generally opens with wide gap.
    Regarding – short call, covering short put, it only partially covered cause short put has unlimited /open risk, whereas short call comes with Limited reward.

    I am not sure, if you traded in May2008 (our election result day). Try to backtest short strangle on 15-May and see what happened to it on 18-May. Infact we couldn’t get any trade executed on Monday, and by Tuesday, all damage was done. Similarly backtest for Jan-2008 and Feb-2008.

    Happy Trading 

  • Alpesh
    1 August, 2012, 10:37

    Thanks Anup
    Thanks for your Valuable thoughts and their sharing.

  • Trader anup
    1 August, 2012, 10:43

    Your welcome Alpesh. Hope this exchange of idea has added atleast a few drops in ocean of trading knowledge that you are building up.
    Happy Trading.

  • shankar Vijayaraghavan
    18 October, 2012, 11:52

    Dear Anup, I came across your blog just today and was very impressed with your profile. The way you have gone about chasing your dream is inspiring.I am basically an engineer and have taken up nifty option trading very seriously from end of 2009.I started off with short strangle and moved on with different stratgies as my reasearch and knowledge increased with time.coming to the point now, I currently am on a strategy which involves about 5 or 6 strikes of the next month selling both put and calls Example: if market is at 5700 then my position will be from 5500 to 5900 (or even 5400 to 6000) November series, I am contantly figuring the adjustments during the intra month movements of market to maintain some sort of delta neutral, this strategy is perofrming very well from june till now,but I am on a constant persuit to interact with people like you to learn and fine tune.Kindly let me know your first cut feel of my strategy and any immediate advice,suggestions.also let me know if i can use any other forum to explain my strategy more in detail and interact with you better than here.thanks.awaiting your response eagerly.
    shankar vijayaraghavan

  • Anand
    8 July, 2013, 9:07

    I saw your note on Covered calls and I have a different opinion. Agreed that no one can guarantee stock prices however in the above case if Reliance is bought for 800 and falls to 720 and one is reasonably sure of the performance in future one can ‘continue’ to hold the stock for a few weeks/months for the price to come back. Hence the stock selection by itself is an important criterion in Covered calls. If one sells a naked put then the loss must be borne in the same settlement month.

  • Trader anup
    19 August, 2013, 23:26

    Anand, A big assumptions is “and one is reasonably sure”.
    In practical trading, we can’t be sure of anything and it is matter or probability. Hope is not the word in trader’s dictionary. In above example, there is no guarantee that slide will stop at 720 and it can’t go below that. Moreover, there is time aspect to option trading. As options have limited life, the move of stock may or may not happen during that period.
    Happy Trading

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