Possible Outcomes of My Apple Purchase 21 comments
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After some market-neutral long/short plays for several weeks now, I figured it was time to make a long play on Apple (AAPL) and exploit the exorbitant prices investors are bidding options contracts at given the unprecedented market volatility (the VIX is at all time highs).
As I explained recently, due to this increased "fear index," options prices are sky high compared to historical norms, so selling options (with appropriate protection) can be quite lucrative now compared to buying them. On Friday, I exercised the following trades: I bought 100 shares of APPLE at 94.6 = $9460 Outflow, and I sold a Call with April09 Expiry 110 strike for 11.30 = $1130 Inflow.
Possible Outcomes:
Immediate Option premium Income: The immediate income from selling the option is 12% over less than six months until expiry.
If shares remain below strike at expiry: Simply put, the total return on the strategy would be the actual return of Apple shares (positive or negative) + 12%.
If shares exceed strike at expiry: If Apple shares run, the return will be capped at the 17% runup from 96.4 to 110, plus the 12% I'm guaranteed from selling the option for a max of 29%. So, if it's a 100% bonanza for Apple, then yes, I've forfeited that opportunity for a 12% hedge.
For beginners to options, I recommend researching various plays, risks and protection further. However, just understand that there's a night and day difference between covered call options and naked options. If you don't know what they are now, stay away!
Disclosure: The author owns AAPL.
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This article has 21 comments:
...And you call yourself Long???
You probably have forgotten ABC haven't U
Also, what is the best introduction to options trading (book).
I like the simple way you explained this strategy. I am planning to do a similr one with GE. For WBE, check out this introductory artice into options: www.savingtoinvest.com...
> However, just understand that there's a night and day
> difference between covered call options and naked options.
A long stock plus a short call option (which is essentially the covered-call) has EXACTLY the same risk-reward ratio (or rather is synthetically equivalent) as a SHORT (aka naked) put. :)
The two strategies are nothing alike. Your upside loss is capped by selling a "covered" call, whereas your downside is unlimited when selling a put until it hits zero. The one I highlighted has clearly defined benefit upward and a breakeven even if the stock declines. I intend on holding the stock regardless-at least when you own the shares, you can hold as long as you like and you never take a loss until you actually close your position...a put forces you to close out during what may be a horrible time (imagine if you sold several puts with Nov2008 expriy and had to close them out this month?); it's actually less risk than just buying the shares outright (which is investing 101) since you capture a nice premium at historic highs due to VIX. Not sure what your gripe is.
I would have thought you would know more about the strategy if you are writing about it.... But nevertheless.
There are some differences:
- Covered call requires more capital vs. put writing
- Covered call entitles you to dividends
- Calls generally have slightly higher premiums than puts, everything else being equal
- Covered calls cost more in transaction costs
Oher than these slight differences, they are functionally very similar.
To reiterate if you sell a naked-put for a stock worth $30, the maximum you can lose is $3000 (100 shares per one option). This happens when the stock goes to ZERO.
With covered call, you still *own* the stock, remember ? So if the stock
goes to zero, you still lose all your money (100 shares of the $30 stock).
For any number X between 0 and 30, you lose $3000 - X in both the cases.
In the naked-put case, you offset a small loss by collecting the naked-put premium. In the covered-call call, you offset the small loss by collecting the covered-call's premium.
It is very ironic that even big brokerage firms sometimes don't exactly understand the differences. They allow a covered-call-strategy in your IRA but do not allow a naked-put.
If you are still unconvinced, pick a calculator, excel or write a small program in your favorite language and work out all the possible profit-loss scenarios for all possibilities of the stock price. :)
Number one lesson one learns in options is this :
Long Stock = Long Call + Short Put
[Of course, I am simplifying interest rates, dividends, capital requirements
and all that goodness]
This is very intuitive to understand.
Left side of the equation : long stock.
if stock goes up, you make money.
if stock goes down, you lose money.
Right side of the equation : long call, short put.
if stock goes up, you make money (via long call).
if stock goes down, you lose money (via short put)
If you add the capital requirement part, and the interest rates that you could have earned and the dividend (if applicable), you will arrive at the EXACT same scenario in both the cases. [i mean the theoretical prices of the options - but real market prices will vary slightly but not more than a few cents here and there].
This equation is exactly why the market-makers are able to take the "other" side of any and every trade because they can hedge by doing the _opposite_.
"It is incorrect to say your loss is "limited" on a covered call because you won't be selling the stock. The outcome is indeed the same as Krishna mentioned: in both cases, if the stock closes below the strike price you end up being the owner of the stock (the put buyer will assign you the stock, remember? And in that case, just as in the call, you pocket the premium)."
Well, most people would prefer to close out the position rather than being assigned the stock, which may result in a margin call or some other poor use of capital. That's why I was referring to a run down to zero on a put you sold (assuming you closed it out close to expiry and it wasn't assigned back yet).
"It is very ironic that even big brokerage firms sometimes don't exactly understand the differences. They allow a covered-call-strategy in your IRA but do not allow a naked-put."
Why wouldn't a firm allow you to do covered calls? It's tied to owning stock long which is investing 101. Selling a call on stock you own does not increase your risk or exposure in any way. It essentially just caps your upside...not catastrophic. Conversely, selling unsecured puts or calls for that matter opens you up to leveraged losses. In the example I provided, I actually needed the ~$9500 to execute the strategy and sold a single call to "cover" an upside move. If I wanted to do your put sale method, in theory, one could sell an infinite number of puts and be out an infinite amount of money if there were no capital requirements or flat out restrictions on such moves and the stock moved below strike. I think it is reasonable that in an IRA account, which is supposed to be a retirement account for long term investing, naked position are disallowed.
Please read what I wrote again. I said it is ironic that the brokerage firm allows covered-calls but does not allow naked-puts. So yes, they do allow covered-calls. That's what I said too.
Again, I understand the differences. Even with a naked-put, you can also stop out anytime you want, once the stock falls below whatever your limit of pain threshold is.
Also, by buying stock, you have already committed the $9500 but with naked put the brokerage firms would just expect you to keep it there so in case the stock goes to zero, they can take it and be covered. That's all - and again, all the cost of carry, interest rate factors, dividend factors are taken into account when pricing the options.
All I am saying is that both the trades are exactly one and the same - risk and reward wise. You can look at them in different ways and say, in one case, you can say, I am comfortable throwing $9500 first and then capping my upside and then stopping out anytime the stock falls below a particular limit OR you can say, let me just collect premium, but set aside the $9500 that will be the max cap needed and when the stock starts falling, you can stop out anytime saying, enough is enough, I have taken my losses - let me get out of this trade.
And one more thing, if one wants a good return from covered-calls, first off, the basic idea would be to sell the at-the-money option in the front-month - that's the best way to get the long term return.
Finally, to reiterate, there is NO night and day difference between covered-calls and naked-puts. That's precisely the common misconception that I wanted to point out. You can emotionally give them all the difference that you wanted to give it, but mathematically and statistically, they are exactly the same.
So, when NVDA was at 19...halted...and opened the next day at 14 or so I could stop out at 17?
I think not. Your naive in thinking the two are equivalent. They aren't. If you put yourself in the realm of infinite capital they are, otherwise they aren't even close.
It is NOT ironic that the IRA would allow you to do covered calls but not naked puts. An IRA cannot be funded at will. You could easily go negative with the scenario I mention above if you are short puts. Then what do you do? That would be a tax nightmare.
Yes, the put-spread you defined is a defined-risk-defined-r... strategy. And that is way better than both covered-call and the naked-put. But thinking that covered-call is limited-risk but naked-put is not is what is incorrect - since the stock can go to zero - so whether you own the stock or whether you are short-the-put, you lose the same amount of money.
But for anyone who is seriously investing their money, please do your own deep and detailed research. Open excel, or your favorite spreadsheet/charting program or write a small script in your favorite programming language and plot the profit-loss-graphs and figure it out yourself - that's the best way to learn this.
Here is the opening two paras from wikipedia :
en.wikipedia.org/wiki/...
A covered call is a process in which one owns shares of a stock or other securities, and then sells (or "writes") a corresponding amount of call options. Payoffs on the stock are always the same, as with a short put option, hence the price (or premium) should always remain the same, as with a short put or naked put.
Writing a covered call generates income, in the form of a premium; however, the risk of stock ownership is not eliminated. Therefore, potential loss is equivalent to subtraction of the total amount paid as premium. Also there is potential upside down through this strategy.
You can also check out cboe.com and read these definitions of synthetic stock and synthetic put :
www.cboe.com/LearnCent...
Synthetic Put
A strategy equivalent in risk to purchasing a put option where an investor sells stock short and buys a call.
Synthetic Stock
An option strategy that is equivalent to the underlying stock. A long call and a short put is synthetic long stock. A long put and a short call is synthetic short stock.
So my understanding seems to be corroborated by wikipedia.org and cboe.com. In the end, your own research is your best option.
You cannot lose more than all your money in covered calls. Period.
Say, you have $10K, you would buy aapl at $9000 and sell a covered call.
So now if you want to use the alternate strategy, you have to do the same exact equivalent. Which is just short one put. And keep the $9000 as the margin to cover.
I never once meant to say that you should short a 100 puts or whatever amount and risk the entire $10K times the leverage-amount in risk.
So I think you were probably assuming that I meant to say sell as many puts as you want - you are comparing two trades of completely different sizes. That was never my recommendation - nor was I talking ever talking about taking on a leveraged bet. I was comparing apples-to-apples. (pun-intended). [100 shares and 1 call OR just 1 short put] :)
Hopefully that clears the confusion.
This is a good starter book. Not sure if the same info can just be found for free but it discusses this very strategy and others in detail.
Winning with Options,
by Michael Thomsett