Buy-Writes vs. Naked Puts in Options Trading - Cabot Wealth Network

Buy-Writes vs. Naked Puts in Options Trading

options terminology: What are Options in Investing?

Buy-writes and naked puts may seem to be drastically different trades, but they’re effectively identical for options traders.

As I’ve written in the past, put sales and buy-writes/covered calls have the exact same risk and reward. And when I’ve recommended buy-write trades, I’ve noted that selling puts is an alternative because they are the same trade.

A Buy-Write is “Synthetically” Identical to Selling a Naked Put

Buy-writes, also known as covered calls, are one of the general public’s most popular options trading strategies. Selling naked puts (the sale of a put in a stock or index without a stock position), on the other hand, is feared by the general public because it’s considered to have much greater risk than a traditional buy-write. But when you break down the profit and loss potential of the two strategies, you can see that they’re identical.

How Options Work

Free Report: How to Hedge Portfolios with Options

Once considered a niche segment of the investing world, options trading has now gone mainstream.

With little knowledge on the best strategies, you can use options to work the odds in your favor and make trades that have up to an 80% probability of success. Find out how in this free report, How Options Work—and How to Hedge Portfolios with Options.

Read Your Free Report Here.

Let’s start by looking at a buy-write/covered call:

A covered call is a strategy in which the trader holds a long position in a stock and writes (sells) a call option on the same stock in an attempt to generate income. Because the trader sold a call against his stock position, his upside is now limited.

For example, let’s say you own 100 shares of Alcoa (AA), which is currently trading at 54.15. You then theoretically sell one AA November 55 Call (expiring 11/19/2021) for $2.80 for each of your 100 shares.

Let’s take a look at a few buy-write/covered-call scenarios for the trade:

AA shares trade flat for the next month and the stock stays below the 55-strike price. The options you sold will expire worthless and you will have collected your full premium of $2.80 per share ($280). Thus you will have created a yield of 5.2% in one month’s time.

AA shares fall to 51.35. The options you sold will expire worthless and you will have collected your full premium of $2.80 per share ($280). However, your 100 shares of AA will have lost $280 of value. Thus, you are breakeven on the trade. At this time, you could simply sell the next month’s calls against your stock position.

AA shares fall to 51. Once again, the options you sold will expire worthless and you will have collected your full premium of $2.80 per share (or $280). However, your shares of AA will have lost $315 of value, leaving you down $35 on the trade. At this time, you could simply sell the next month’s calls against your stock or exit the entire position by selling your stock.

AA shares rise above 55. At this point, the owner of the 55 calls will exercise his right to buy the stock from you. This will leave you with no position. However, you have collected your $2.80 (or $280) and made $0.85 on the stock position.

Now let’s take a look at the scenarios of selling a naked put in the same stock. (Remember, selling naked puts is the sale of a put in a stock or index without a stock position.) With the stock AA trading at 54.15, we could sell the November 55 Puts (expiring 11/19/2021) for $3.65.

Let’s take a look at a few naked-put sale scenarios for this trade:

AA shares trade flat for the next month and the stock stays below the 55-strike price. At this point, the options you sold will expire in the money, and you will have collected your premium of $3.65 per share ($365). Now you will be long the stock, but will have created a yield of 6.6% in one month’s time. At this time, you could simply sell the next month’s calls against your stock position.

AA shares fall to 51.35. At this point, the puts you sold will expire in the money and you will buy the stock at 55. However, since you collected your full premium of $3.65 per share ($365) this makes up for the loss on the stock. Thus, you are breakeven on the trade. At this time, you could simply sell the next month’s calls (switching to a buy-write now that you own shares) against your stock position.

AA shares fall to 51. At this point, your puts are in the money so you will be forced to buy the stock at 55. You will have collected your full premium of $3.65 per share (or $365). However, your shares of AA will have lost $400 of value, making you down $35 on the trade. At this time, you could simply sell the next month’s calls against your stock or exit the entire position by selling your stock.

AA shares rise above 55. At this point, the puts you sold will expire worthless and you will have collected your full premium of $3.65 per share, a yield of 6.6%.

So what jumps out about these two scenarios? They are identical! The most you can make is the same, and the most you can lose is the same.

We can go through this exercise hundreds of times but each time the profit and loss potential will be identical. Thus, executing a buy-write is “synthetically” identical to selling a naked put.

Do you prefer buy-writes to increase returns on your new positions or naked puts to target unowned positions at your chosen price?

Jacob Mintz

Quick Profits, Controlled Risk

Jacob Mintz is a professional options trader and Chief Analyst of Cabot Options Trader. He uses calls, puts and covered calls to guide investors to quick profits while always controlling risk. Beginners and experts alike can gain from following Jacob’s advice.

Learn More

*This post has been updated from a previously published version.

Comments

You must log in to post a comment.

Enter Your Log In Credentials

This setting should only be used on your home or work computer.

Need Assistance?

call Cabot Wealth Network Customer Service at

(800) 326-8826

Send this to a friend