Covered Calls and Naked Puts

Some have asked whether a covered calls and naked puts combination is an option trading strategy worth considering. The best way to answer that is, that it depends how you choose to do it.

There is a profitable low risk way, which you could also call “Using Options to Buy Stocks”. The basic idea is that when you believe a stock is due for a reversal from its present downward price movement, possibly because it is not far from a strong price support area, you sell naked put options at the strike price you are prepared to purchase the stock. In return, you will receive a credit to your account for the option premium. best naked cam sites

If the price of the underlying continues to fall to the anticipated support level, you will most likely be exercised and the underlying shares, commodities or whatever, will be yours. You then immediately sell call options at a strike price above your purchase price for further income.

If the underlying never falls to the anticipated price level however, you simply keep the put option premium at expiry date.

Using this covered calls and naked puts strategy, you increase the income you receive and at the same time, lower your overall risk of holding the shares if they are assigned to you.

With some imagination, you could also protect yourself by entering a put credit spread at the price level you are prepared to own the stocks. Since you will be purchasing near month expiry options, the way-out-of-the-money “bought” put would cost you mere cents and provide some protection should the underlying price fall sharply.

There is also a less desirable, more risky, way to employ the covered calls and naked puts trade.

Let’s explore another possible covered calls and naked puts scenario.

Imagine a company, let’s call it XYZ, is currently trading at $20 and you believe it is due for a rise in the next month or so. So you do the following:

1. Purchase XYZ at $20
2. Sell $22.50 XYZ call options with expiry next month out and receive $1.50 premium
[this part is your normal covered call]

3. Simultaneously sell (short) $17.50 put options and receive a further premium of $1.50. You would need enough collateral in your brokerage account to cover the additional purchase of the equivalent number of XYZ shares in your option contract at $17.50 each.

Analysis of Covered Calls and Naked Puts position:

You have now taken in $3 in options premium to offset the cost of your $20 purchase price on XYZ shares, bringing their effective cost down to $17 per share.

You are also now obligated to sell these shares at a maximum price of $22.50 should the market price rise above that amount.

You are also obligated to purchase a second lot of shares at $17.50 should the market price of the stock fall below that level.

As long as the stock price remains somewhere between $17.50 and $22.50 at option expiry date, you get to keep all the premium you have taken in and since $3 is more than the maximum $2.50 loss on the shares, you make an overall profit as well.

But say XYZ stock becomes volatile and the price moves sharply either way? The bottom line is, that if it goes north, you make even more profit, but if it tanks below $17 you could be in trouble.

Here’s why.

Imagine the stock price rises sharply and at option expiry date, is trading at $25. At this price, your call options will likely be exercised and you will be forced to sell your shares for $22.50 – but here you make a further $2.50 profit on the stock and all positions are closed, leaving you with a total profit of $3 option premium plus $2.50 from the stock = $5.50 per share total profit. Nice!

But if XYZ plummets to $15 what are we looking at then? It’s times like this that we are faced with the stark reality of what “naked’ really means when it comes to selling options.

At $15 market price, your account would look like this:

1. There would be a $5 capital loss on your XYZ shares
2. You would also be forced to purchase a FURTHER lot of XYZ shares for $17.50 when you could buy them on the open market for only $15 – a $2.50 theoretical loss on purchase (you never actually realize a loss until you sell the shares)

Your position is now down $5 plus $2.50 = $7.50.
But this is offset by the $3 option premiums you took in from shorting the calls and puts.
So your overall net loss at expiry date is $7.50 less $3 = $4.50 per share.

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