What is an Inverse Covered Call (The answer may surprise you)

The following excerpt is taken from my book Show me Your Options co authored with Christopher Ebert the “Option Scientist”.

(The following chat is set inside a facebook group in 2011, Apple has appreciated greatly since this book was published).

Income Investor: I heard you were the group’s resident guru on stock options. I sell call options for income on my investment portfolio. The strategy is not working out as well as I had hoped.

Optionz Traderz: Why don’t you just sell Naked Puts for income instead?

Income Investor: I would never sell a Naked Put; that is way too much risk. It makes my stomach queasy just thinking about it.

Optionz Traderz: Well, I have some news for you. They are the same thing as covered calls, technically.

Income Investor: What? That is crazy they are completely different, Covered Calls are for income and naked puts are a wild gamble with huge risks.

Optionz Traderz: How is the risk in a Naked put different from a Covered Call?

Income Investor: A stock could crash and you would still have it put on you at a set price much higher than what it was worth currently at the market price.

Optionz Traderz: But you receive income for the Naked Put.

Income Investor: That is a small fee for taking on the risk of a stock crashing and possibly causing me to be left holding the bag. This could cause me to have to buy a stock for way under the market value.

Optionz Traderz: How is that different from Covered Calls?

Income Investor: I already own the stock I am writing the call. I do not have the risk of having it put on me.

Optionz Traderz: That is because you already put it on yourself.

Income Investor: It is an investment.

Optionz Traderz: Then why would you not sell Naked Puts on stocks you would want to own, and if they were put on you, it would be initiating an investment?

Income Investor: I do not like the idea of offering to buy a stock at a set price.

Optionz Traderz: With a Covered Call you are offering to hold a stock for a set price and risk the entire downside. What is the difference?

Income Investor: I already own the stock.

Optionz Traderz: Correct, you already own the downside.

Income Investor: I own the downside? I never really thought of that.

Optionz Traderz: In a Covered Call you get paid a small fee to take on the downward risk of the stock that you own. In a Short Put you collect a small fee to take on the downward risk of a stock you must buy at the strike in the future if exercised. It is the same trade, same risk.

Income Investor: Okay, that makes my head spin. I can’t believe that a Covered Call option has the same risk profile as a naked put.

Optionz Traderz: Say you own Apple at $385 and you sell a Covered Call option at $390 and collect $15. You make money from $370 and up in price. If you sell a Naked Put at $390 for $15 you make money from $370 and up in price. Your risk is to the downside in both strategies. The difference is that you already put Apple on yourself before you entered the trade on the Covered Call, and in the Naked Put you will have it put on you later.

Income Investor: I am taking on the same risk in both of these trades?

Optionz Traderz: Exactly the same risk, the only difference is when you take it and whether it is you or the brokerage firm that is exposed to the downside. I have discussed this in the group a few times; it is one of the greatest misunderstandings in the option world. The risk embedded in the Covered Call, the infamous ‘stop gain,’ is the same as a Naked Put, to the trader. If you sell a large amount of Naked Puts and some unforeseen event results in a loss that is greater than the entire value of your brokerage account before a margin call can be executed, it is the broker who is on the hook.

Income Investor: I really thought I was an informed investor, but that just blew my mind.

Optionz Traderz: In investing and trading financial markets, all we are doing is trading risk. Each instrument has an upside and a downside and generally an equal chance of the trade moving towards or against our bet when we enter any position. The market’s current behavior determines if we win or lose, not our own genius.

The rest of this book can be found on Amazon through this link: Show me Your Options.