January 16th, 2015
by Russ Allen, Online Trading Academy Instructor
In the last few articles I discussed covered calls (long stock together with short calls). This strategy is a popular income-generating technique. There is a good reasons for this - it works. But no discussion of covered calls would be complete without mentioning that we can do a strategy with the same dollar risk and reward, but with less money out of pocket.
Like any alternative that increases leverage, this can cut both ways. Whenever we consider using higher leverage we must be aware that we are increasing our risk. But for traders who are willing and able to handle the increased risk, it is worth a thought.
The strategy I'm referring to is simply selling naked put options. When the increased leverage results from the smaller margin requirements for the equivalent position.
Here is an example, on January 7, 2015, the exchange-traded fund QQQ closed at $101.36. Its options were extraordinarily expensive compared to recent history so option selling strategies were called for. Its recent highs around $105 appeared to be a good target for the next few weeks.
The March $105 calls were quoted at $1.50. All of this amount was time value since these call options were out of the money. The March $105 put options were at $5.33. These puts were in the money by $3.64 (strike price of $105 less stock price of $101.36). Subtracting the $3.64 of intrinsic value from the $5.33 put price leaves $1.69 in time value in the puts. This was $.19 more than the $1.50 of time value in the call options. This small difference in time value is accounted for by the fact that a dividend of about that amount will be paid during the options' lifetime. The time value of a put and a call at the same strike must be the same, after accounting for interest and dividends.
Let's look at a covered call compared to a short put position. For the covered call, we could buy QQQ at $101.36 and sell the call option for $1.50, for a net out-of-pocket amount of $99.86 per share. We'll consider three scenarios for QQQ's movement over the 72 days until expiration: unchanged; at or above $105; and down about 10% to $91.
Scenario 1 - QQQ unchanged
If QQQ remained where it was until the March expiration this trade would make $1.50. There would be no profit or loss on the stock. The call would expire worthless leaving us with the $1.50 credit received for the call as our profit.
Now let's consider the short $105 put. With QQQ still at $101.36, the $105 put would still be in the money by $105 - $101.36 = $3.64. This would be its intrinsic value. Since its time would have expired, that will be its total value. We can buy back the put for $3.64. Subtracting this amount from the $5.33 that we were earlier paid for selling the option short, our net profit would be $5.33 - $3.64 = $1.69. This is $.19 more than the covered call profit of $1.50, but the covered call owner would have received the $.20 dividend. A tie.
Scenario 2 - QQQ above $105
If QQQ were to be at or above $105 at expiration, the covered call would look like this: the stock would be called away from us, and we would receive the $105 strike price in payment. Our earlier net out-of-pocket cost was $99.86, so our profit would be $105 strike price - $99.86 = $5.14. This would consist of the $1.50 we got from selling the call, plus a gain of $3.64 on the stock. We would also receive a dividend of about $.20, for a net gain of $5.34.
For the short put, our profit calculation is simple. We will have received $5.33 originally for selling the put, and we get to keep it. Again, a tie.
Scenario 3 - QQQ down 10% to $91.36
In this case the covered call would show a loss equal to our original net cost of $99.86 less the current value of $91.36, or $8.50 per share. We've lost $10.00 on the stock, but we get to keep the $1.50 for the call. We also get the $.20 dividend, for a net loss of $8.30.
The short put, meanwhile, would be in the money by the difference between the strike price and the stock price or $105 - $91.36 = $13.64 per share. We would have to pay this amount to exit from the trade. This could happen in one of two ways: we could just buy the put back for $13.64. Or we could allow the QQQ stock to be put to us. In that case we would be forced to pay $105 for it. We could then sell it at its market value of $91.36, for a loss of $13.64. Either way, it costs the same. Subtracting our original proceeds of $5.33, our loss on this trade would be $8.31. The same as the covered call.
Okay, fine. The short put and the covered call are equivalent at any eventual QQQ price if the position is held until expiration. So, how does the short put position provide more leverage?
This comes from the margin requirements of the two positions. For the covered call, at a minimum we'd have to use 50% margin for the stock, or .5 X $101.36 = $50.68. We would receive $1.50 for the call, which leaves a net margin requirement of $49.18. We would be subject to margin calls if the stock dropped below the maintenance margin requirement. We would be borrowing $50.68 for the duration of the trade, and would have to pay interest on that.
For the short put, our margin requirement would be 20% of the strike price, or 20% X $105 = $21. We would likewise be subject to margin calls if the stock dropped. We would not incur any margin interest.
So in this comparison, the covered call and the short put pay off exactly the same whatever happens to QQQ. But the short put does it for less than half the margin requirement - $49.18 in margin for the covered call vs $21.00 in margin for the short put. If the position shows a profit, the percentage return on cash tied up will be more than twice as high for the short put. And if the position shows a loss, the loss as a percentage of our money tied up will also be more than twice as much.
This last sentence above is what we must always keep in mind when we consider using leverage. Above all, we should never risk more than we can afford to lose on any trade.
I hope this illustration of the equivalence of different positions has piqued your interest in options. If so, consider contacting your local center about our options course offerings.
For comments or questions on this article, contact us at firstname.lastname@example.org.