BUNK 13
COVERED CALLS . . . GOTCHA COVERED
The name “covered calls” alone is comforting—even if you don’t know what it is! Who doesn’t want to be covered? As in, “Hey, dude! Don’t sweat it; we gotcha covered.” Or, “If you’re cold, get covered up.” Just sounds right.
Technically, covered calls combine a long stock position and a written call option. Many investors like these because they get a little bit of instant income from the premium received from selling the call. And there’s not much risk from the call option. If the stock rises to the strike price before the expiration date, you just hand over the stock. That’s why it’s covered. Sounds safe! Income and seemingly low risk! How cool is that? That’s how they are usually sold in the brokerage world.
At the same time, most folks who like covered calls and think they’re safe will say with certainty that naked puts are risky. Covered is safe, but naked is crazy risky! Naked just sounds bad. “Hey, dude, you’re hanging out there naked.” Or, “I was warm until I got naked in the snow.” But naked and covered don’t mean what you may think or what most investors think. In this case, and counter to what every single covered call operator I’ve ever seen believes, they mean mathematically exactly the same thing—as I’ll show you.
A naked put involves a written put option, so you still get the premium income, but you don’t have a position in the underlying security—you’re naked. I guess only nudists don’t fear that. And naked means your loss can be the total strike price, minus whatever premium you collected. But the strike price is normally much more than the premium—so you can have a substantial loss.

Covered Calls Are Just Like Naked Puts?

So a covered call is thought to be safe and smart, and a naked put risky and crazy. Right? Bunk. Despite cosmetic appearances and urban myth, do the math and you’ll discover that a covered call and a naked put are effectively exactly the same thing. Yet no matter how many times I tell this to covered call fans they never do the math and never figure it out and won’t believe it.
Figure 13.1 shows the potential payout of a covered call at the exercise date. As with all options positions, the range of possible exercise profits and losses are known. The x-axis shows the stock price at the exercise date, and the y-axis shows profit or loss from this position. X is the strike price of that option.
The covered call actually pays out a fixed amount for an increasing stock price. Your potential upside is limited because you must hand over the stock if the option exercises. Worse, you still have all the downside risk of stock ownership, less only the premium. Capped upside, basically unlimited downside—doesn’t sound so great anymore.
In fact, stated that way, it sounds exactly like a naked put. Because it is! No difference. And finance theory says that two securities with identical risk and payouts are, indeed, the same security—as shown in Figure 13.2.
Folks who think covered calls are safe and naked puts risky delude themselves. The perceived safety of a covered call is just that—perception. So if they are identical, with identical potential payouts and risk, why the perception gap? This is a standard cognitive error studied in behavioral finance. Identical information can be perceived differently depending on the framework it’s presented in. So investors who do covered calls thinking they are safer than naked puts are simply fooled by framework—nothing more.
Figure 13.1 Covered Call Possible Payout
015
Figure 13.2 Covered Calls and Naked Puts
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So, the next time someone suggests you do a covered call, you can say, “No way! I might as well sell a naked put!” Because you’d be right.
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