Attention brokers. If you want to get into a business you should know the business.
Brokerage firms have been putting more time and money in to building and marketing their option services and trading platforms to capture this growing market. But these firms keep showing an incredible lack of understanding about the role of options in a portfolio, presuming they are too risky. This false presumption manifests itself in the form of strict trading restrictions many brokers place on customer accounts.
The most obvious of brokerages' blind adherence to the misplaced belief that most investors need to be protected from themselves takes the form of nearly blanket restrictions placed on selling or shorting options naked. The recent launch of the TheStreet.com Options Alerts really brought home how ubiquitous these irrational trading restrictions are, as I received numerous emails from subscribers describing their frustration at not being "allowed" to sell put options because they don't "qualify" to engage in this type of option transaction.
Being naked options refers to shorting an option without owning an offsetting position that would limit risk to a defined amount. This means it does carry a high level of risk. But to be perfectly clear, the monetary risk of selling five put-option contracts is essentially the same as buying 500 shares of the underlying stock. And no broker I know of prevents investors from "going naked long stock." The only restriction comes in the form of a margin requirement, but if the account has sufficient funds to buy 500 shares it also has sufficient funds to sell five puts.
The difference between being long stock vs. being short puts is on the reward side of the equation, not the risk. So these firms either don't understand options or are simply being hypocritical, in the application of their own rules regarding trading requirements.
Highlighting the inconsistency of their rules is the fact that most of these firms have no problem letting people engage in buy-writes, or covered calls. A covered call consists of going long a stock and selling short the related call options. Again, let's be perfectly clear, the risk
and the reward
of a covered call is exactly the same as a naked short put. Both have a limited profit potential vs. a potential loss that is limited only by the fact that a stock's price cannot decline below $0. Because trying to explain this to your broker likely will get you the standard response of "I understand, but these are our rules" it is helpful to understand the concept of equivalent and replacement positions.
To illustrate how a covered call is an equivalent position to a short put let's run through the numbers using
, a favorite stock for writing covered calls because of its healthy dividend.
The stock was trading at $67.80 Wednesday, when you could sell the September $70 call at $1.20, creating a covered position that has a maximum profit of $3.40 ($70-67.80+$1.20=$3.40). The break-even point is $66.60 (the stock price minus the premium sold ($67.80-$1.20=$66.60). The maximum loss is $66.60, should the stock go to zero.
One could short the September $70 put for $3.65 per contract, which also represents the maximum profit. The break-even point is $66.35 (the strike minus the premium collected $70-$3.65=$66.35).
You'll notice the short put seems to offer a 25-cent advantage over the covered call; this is because the option prices have taken into account the dividend payment. The covered call, through the long stock, qualifies to receive the Altria dividend payment, making the two positions virtually identical.
The same type of calculations can be made for selling calls vs. a covered put (shorting stock and selling puts). The maximum risk of all these equivalent positions is actually less than being outright long or short the shares. Because all accounts are subject to margin requirements, both initial and maintenance should the position move against you, I see no reason why brokers are so restrictive in allowing people to go "naked" options. If the account has sufficient funds to buy 500 shares it also has sufficient funds to sell five puts.
Aside from covered calls and covered puts, there are four other combination positions that have a single instrument equivalent:
-- Long stock combined with long put (married put) = long call
-- Short stock combined with long call = long put
-- Short call combined with long put = short stock
-- Long call combined with short put = long stock
Similar but not Equivalent
While there is a limited number of truly equivalent positions, there is an endless number of positions that offer a similar directional bias that can be utilized to profit from an expected price move.
The most basic example of similar positions is selling calls short vs. buying put options. While both positions represent a bearish bet, they perform and produce very differently under the same set of circumstances.
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 limited only by the fact that stocks don't trade below zero.
Using a generic example, assume XYX Corp. pays no dividend, trades at $47.50 and its June $45 put could be had 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. But as 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 earn only $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.
The same analysis can be applied to more complex, or multistrike positions. For example, it is always worth comparing a debit put spread with a related credit call spread. They are similar in that both positions have a bearish bias and offer a limited risk/reward profile, but the break-even points and prices needed to achieve a maximum profit are different.
So when your broker doesn't let you sell puts because they don't allow "naked" options, just smile knowingly and look for a "less risky" alternative and a more intelligent broker.
Steven Smith writes regularly for TheStreet.com. In keeping with TSC's editorial policy, he doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He was a seatholding member of the Chicago Board of Trade (CBOT) and the Chicago Board Options Exchange (CBOE) from May 1989 to August 1995. During that six-year period, he traded multiple markets for his own personal account and acted as an executing broker for third-party accounts. He appreciates your feedback;
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