Steven Smith

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Options Forum: Know Your Strategy

Steven Smith

Would you please explain what the difference is between short-selling a call option and just buying the put option? -- M.C.

While both positions represent a bearish bet -- that is, they profit if the price of the underlying common stock declines -- they perform and produce very differently under the same set of circumstances.

Understanding the differences in cost, risk and price behavior of each position is crucial in determining which strategy best aligns with your predicted scenario. Do not confuse two similar bearish positions as being parallel, or replacements for each other -- a short call has a completely different profile than a long put.

The profit potential from selling a call is limited to the amount of premium sold, but the potential loss is unlimited. A long put option position has almost the inverse risk/reward profile: The maximum potential loss is limited to the cost of the option, while the profit potential is nearly unlimited. Only the fact that the price of the underlying stock cannot drop below zero prevents me from saying it is truly unlimited.

For example, let's assume XYX Corp. trades at $47.50 and one could buy the June $45 put for $1.50 a contract. The break-even, or effective, sale price is $43.50, 7.4% below the current $47 share price. If XYZ shares are above $45 on expiration, the option will be worthless and the position will realize the maximum loss of $1.50 a contract. Even a 5% decline in the stock price could result in a loss on the long put position. If XYZ declined below the $43.50 break-even point, the profits would increase as the stock declined.

By contrast, the strategy of selling the June $50 call short at $1.50 could realize its maximum profit of $1.50 even if XYZ shares increased to $50 per share. But if the shares tumbled to $40, the short call still would only earn $1.50 per contract while the put would be worth at least $5 per contract, or a 325% increase.

Selling the call short leaves a lot of money on the table. Therefore, selling calls might not be the best strategy on a stock that you think could suffer a precipitous decline.

Costs vs. Rewards

Another factor to consider when choosing positions is the return based on the capital or margin requirement needed to establish the position. This provides a truer reflection of an strategy's potential return on investment.

When buying options, the ROI formula is fairly straightforward: The capital requirement is equal to the purchase price of the option. But ROI gets slightly more complicated when you're selling options.

The margin requirement for selling an uncovered or "naked" call is the greater of:

1. 20% of the stock price plus the call premium, less the amount that the call is out of the money, or
2. 10% of the stock price plus the call premium.

In the XYZ example above, the margin requirement equation is (0.20 x $47.50 + 1.50) - 2.50 = $8.50, or $850 per call sold. (The latter formula results in a requirement of just $800, which is the lesser of the two and therefore not applicable.)

Use the margin requirement as the basis for calculating the return on investment for the position. In XYZ's case, assuming the call expired worthless, the ROI would be 17.6%, which is derived from dividing the profit by the initial margin requirement ($150/$850). Remember that this was achieved in just a seven-week period, and there is no reason to annualize the return. Still, even without annualizing the return, this formula illustrates the leverage of options and the power of time decay.

Achieving a similar return by buying the underlying shares would have required both $2,375 of initial capital (100 shares at $47.50 with a 50% margin requirement) and XYZ to climb by $4.00, or 8.6%, to $51 per share.

Parallel Positions

These calculations become more important when comparing two parallel positions, or strategies that have basically the same risk/reward profile. For example, a covered call or buy-write has essentially the same risk/reward in dollar terms as shorting its related put. But a look at the initial margin requirement for a covered call shows that these mirror or replacement positions can have very different returns on investment.

The minimum initial requirement for a covered call is:

1. 50% of the stock price less the proceeds from the call sold, or
2. 30% of the strike price.

So a buy-write position in ABC Corp. in which you bought shares and sold the January $30 call on a 1:1 basis would require ($30 x 0.50) - $3.50 = $11.50, or $1,150 per 100 shares covered. (Again, because the latter formula results in just a $900 requirement, the first formula applies.)

The maximum return on investment for this bullish position is 30%.

You also could sell the January $30 put for $3.60, which would have an initial margin requirement of $960 a contract and a potential return on investment of 37%.

Clearly, in this example, selling puts offers a better ROI.

In choosing a strategy, it is important to choose not only which position will produce the maximum gain under a given scenario but which strategy offers the best yield based on the associated costs and risks.