Paper Trade - Covered Call & Naked Put

There's been a lot of discussion on the JustCoveredCalls Yahoo group on covered calls (CC) vs naked/cash secured puts (NP/CSP). Both strategies are synthetic equivalents of each other and have the same risk/reward profile when done at the same strike/expiration. Due to put/call parity, these strategies have about the same net investment and dollar amount return. However, there are differences in capital requirements, especially when trading in a margin account.

Selling an OTM put has about the same net investment and dollar amount return as an ITM covered call with the same strike/expiration (e.g. $20 ITM May CC will be about the same as selling a $20 OTM May NP/CSP).

For those unfamiliar with naked/cash secured puts, let me provide a brief explanation. When you sell a put option you are obligated to buy the stock at the strike price of the put if assigned. So, for example, if a stock is trading for $25 and you sell an OTM $20 strike put, you agree to buy 100 shares of stock at $20/share, or $2,000. You either need to have $2,000 in cash to secure the put or you must have a margin account. At expiration, if the stock stays at $25, the put expires and you get to keep the premium. If the stock falls below $20 the put will be exercised and you'll have to buy 100 shares for $2,000.

This would be the same as buying the stock at $25 and selling an ITM $20 strike call. At expiration, if the stock stays at $25, the call will be exercised and you'll have to sell 100 shares for $2,000. If the stock falls below $20 the call expires and you get to keep the premium. Same results as the NP/CSP only in reverse.

In a margin account, you only need to put up about 20% or $400, depending on your broker, even if you have the entire $2,000 in cash. This dramatically reduces your capital requirement and increases your percentage profit, even though the profit amount is about the same as a covered call. Margin requirements for the stock portion of a CC are usually 50%, depending on your broker. So, you can see that there's a clear margin advantage to trading NP/CSP's vs CC's, even though both strategies are essentially the same.

In a non-margin account, like an IRA, the put MUST be fully secured by cash (i.e. a CSP), so you MUST have $2,000 in cash, to cover the cost of the stock. In this case, $2,000 is deducted from the cash available for investment, so even though the $2,000 remains in your account, you can't spend it. However, you do earn interest on that $2,000, but remember options pricing takes interest and dividends into account, so their impact is minimized when comparing CC's vs NP/CSP's.

Since the members of the JustCoveredCalls Yahoo group recently voted to include NP/CSP's in our discussions, I thought I would start a paper trade example on my blog. Since I trade in an IRA I will use 100% cash secured puts and compare that to a traditional covered call.

On 4/9 I established a new CC position on TGT which I'll use for this example. I created a paper trade for the CSP position which I'll adjust at the same time as the CC position over the next several months. Here are the details of both positions:

TGT CC Position (Real Position)

09-Apr-09 - Initial Stock Position - BTO 100 TGT @ 39.78
09-Apr-09 - Initial Call Option - STO 1 May09 37.50 Call @ 3.70

Capital Invested: $3,978.00
Income Generated: $370.00
Net Investment: $3,608.00
Percent Income Generated: 9.30%
Annualized Income Generated: 94.30%
Net Profit If Called: $142.00
Percent Return If Called: 3.57%
Annualized Return If Called: 36.19%
Days Held to Expiration: 36 days

TGT CSP Position (Paper Position)

09-Apr-09 - Initial Put Option - STO 1 May09 37.50 Put @ 1.54

Capital Invested: $3,750.00
Income Generated: $144.00
Net Investment: $3,606.00
Percent Income Generated: 3.84%
Annualized Income Generated: 38.93%
Net Profit If Expired: $144.00
Percent Return If Expired: 3.84%
Annualized Return If Expired: 38.93%
Days Held to Expiration: 36 days

As you can see, the net investment and dollar profit is about the same. However, the capital invested in the CC is greater than the capital invested (cash required to secure the put) in the CSP. If the CC is called away and the CSP expires, the CSP will have a higher percentage return, even though the dollar amount return is about the same, due to the lower capital requirement. If the CC is not called and the CSP is assigned, then the CC will generate more cash and have a higher yield than the CSP. So, there are trade offs for either result.

If TGT is still above $37.50 by May expiration, I'll roll the CC position to avoid assignment and roll the CSP at the same time. If TGT is below $37.50 by May expiration, I'll roll the CSP to avoid assignment and roll the CC at the same time. I'll do this for a few months so we can see the long term affect of using both strategies. TGT also pays a dividend, so we will also see the affects that will have on both positions. For simplicity sake, I will not include interest in these examples, since that's a bit harder to track.

Anyway, I hope this will be a useful exercise and help people understand the similarities and differences of these two strategies.