Look, I get it.
Maybe you have some long-term holdings showing significant gains that you don’t want to pay taxes on. But you want to squeeze some additional income out of these positions because either you’re greedy (fine) or you want to practice responsible risk management (a better reason).
That’s fine. Go ahead and continue selling covered calls from your yacht. You do you.
This post is aimed at the rest of you knuckleheads who seem to think entering covered call trades as tactical short-term plays is a productive use of your time and capital.
Yes, you! You know who you are.
Let me show you two pictures.
The first one is a hypothetical PnL graph for a typical covered call trade. I’ve used MSFT in this example, but it could be any large-cap stock:
Here we’re long 100 shares and selling the 240 calls. We’re exposed to the same downside risk as a long stockholder, less the credit we receive from the calls.
Next is a hypothetical PnL graph on the same stock. But this time, just selling a naked put at the same strike and expiration:
Look at the PnL curves between the two charts? Notice anything different?
No. You don’t. The risk-reward profile is exactly the same.
But there is one important difference between these two seemingly identical trades that can play significantly in the favor of short put sellers over time: Cost.
With a covered calls trade, you need to both purchase the stock and sell a call. Both of those transactions cost money.
I can hear you Robinhood traders screaming from the cheap seats: “But we get ‘commission-free’ trading!!”
Listen kid, if you believe your trades are “free” in the true economic sense, you’re going to have a short life in this business. Even if your trades are “commission-free”, you’ll be paying significant slippage to get into your trades. This slippage will often (and almost by rule) cost more than whatever commissions you may have avoided. You can bury your head in the sand on this if you want. But if you’re an active trader, you can’t ignore this fact.
In a covered call trade, you are therefore effectively transacting twice on the way in, and potentially twice on the way out. These commissions and slippages add up big time over time.
In a naked put trade, you transact once on the way in. And if the stock goes up, the short put expires worthless, you keep all the credit you collected at trade initiation, and have no further trades to make.
Not to mention it’s only one moving part in a naked put trade versus two moving parts in a covered call trade. This is the very definition of simplicity.
And don’t even get me started on the capital requirement!
If I put this covered call trade on, my broker will require me to post up $11,067 of margin to hold the trade. Meanwhile, if I put the short put trade on instead, my margin requirement will only be $4,768. That’s less than half of the margin required for the covered call trade! This means I’ll have more capital to use in other trades to diversify my strategy risk. How is that not a good thing?
Hands down, for tactical trades, the short put wins easily over covered calls. Try some out for yourself and see how it goes.
Then tell me if I’m wrong.
Trade ’em Well,
Chief Options Strategist
All Star Charts, Technical Analysis Research