My Valeant article triggered a couple of questions about how buy-writes and naked puts could be the same trade. And if a couple of readers are asking, I know that others are wondering the same thing. So I thought I would break down our Kate Spade trade to show the math behind this.
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 an stock or index without a stock position), on the other hand, is feared by the general public as 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.
Let’s compare and contrast the profit and loss of our KATE April 23 buy-write against a fictional trade if we had instead sold the April 23 Put.
Buy-Write:
We bought stock at 23.95 and sold the April 23 Calls for 1.65.
If KATE closes above 23 on April Expiration we collect $0.70. How do I get to this value? We bought stock at 23.95. If KATE closes above 23 on expiration we will be forced to sell the stock at 23 by the owner of the April 23 call, for a loss of $0.95. However, we also collected 1.65 when we sold the call. So we now add a gain of 1.65, to the loss of 0.95, which yields a profit of $0.70.
Our breakeven is 22.30. We get this price with this math equation: 23.95 minus 1.65 = 22.30.
Below 22.30, we will lose $100 for every dollar the stock falls.
Naked Put:
Theoretically we sell the April 23 put for $0.70 (which is the price right now).
If KATE closes above 23, we will make $0.70 as the put we sold expires worthless.
Our breakeven is 22.30. We get to this price with this math equation: 23 minus 0.70 = 22.30.
Below 22.30, we will lose $100 for every dollar the stock falls.
Conclusion:
As you can see, the most you can make on both trades is $70 per trade.
The breakeven on both trades is 22.30.
Below 22.30, you will lose $100 for every dollar the stock falls.
The risk/reward profile on these trades are identical.
Why brokerage firms allow some traders to execute buy-writes, and not naked puts is something I will never understand. While the mechanics are different, the risk/reward is identical.
If you have any questions about this, do not hesitate to email me. The market will likely be slow this morning ahead of the Federal Reserve announcement, and I will have time to answer questions.