Its funny how naked puts get such a bad rep when they have the same risk profile as covered calls. I'm not saying I am an advocate of them, but it seems curious because people seem to encourage covered call writing, but warn against the disasters of naked put writing. Please don't tell me it is because covered calls have the underlying as a collateral.. because writing naked puts also requires similar cash upfront as a guarantee.
Pls correct me if I'm wrong on this assumption, but I've always thought that the volatility skews were due to: - most options pricing models adopting the normal distribution instead of the log-normal distribution in their calculation of options prices, hence not reflecting the actual distribution of price movements - the skews result because of the market/specialists pricing these options using the real (aka historical) log-normal distributions And that the reason why different stocks exhibit different volatility smiles is due to the fact that different stocks/securities each having a different skew/kurtosis of their log-normal distributions based on their historical distribution of their movements.
I think it's a question of leverage. By definition covered calls can't be levered, whereas short Puts can be, often with spectacular consequences.
Yes, but I could always write more calls than the amount of shares I actually hold in my portfolio - and raise the balance cash required as margin. It all boils down to discipline.. and controlling your greed.
Yes, covered calls in of themselves can't be leveraged but the margin requirement for a CC can be quite small. For instance, years and years ago when I was with TD waterhouse, the margin requirement would be 25% of the underlying with the call's OTM portion being available for that 25%. In the tech bubble on say CMRC (haha) you could have an OTM call worth 20% of the underlying, which resulted in a 5% cash margin requirement or a possible 20 to 1 leverage. And naked writing has a dangerous feel to it! Covered call writing can be worse. How about when the underlying tanks (which you are long) and the call doesn't drop as much becuause of the volty increase? OUCH.
Hi hlpsg, The problem is we can't know the real distribution. Unknown events are infinite. Here we got trends, gaps, jumps.... For most models, one adopts the fact returns follow a normal distribution ,hence there is a log normal distribution that follows the underlying price. That is why most of stochastic models adopt a geometric brownian motion to simulate underlying behaviour. One can't even know if supposed distribution(s) that would lead prices can have finite mean and/or finite variance. My opinion is that skew is an outcome of a market, and as one, is made of beliefs, improbable stories and rational reasons. One can't, until now, express the skew as being the simple fact of... As I already wrote, no one can tell you that the fair price of an option is today way of pricing. Who knows if skew will disappear or stay. It's just 20 years old, options are traded since 2600 years. Pretty young phenomenon. Interest rate, borrowing ability, exchanges and generally countries rules have an impact on the skew.
I didn't mean to imply there's only one reason people are buying puts. I'm just saying there's a big additional upside pressure on puts from that sector of the market that wants portfolio insurance. I completely agree that the way the skew curves can be though of as eliminating "easy free lunch" relationships - that was the whole point of what I posted in the "The skew part II" thread. But that is based on the inverse relationship between the VIX and the S&P500 - which is caused by people long stock and looking for portfolio insurance each time stocks tick down. So we're back to where we started.
Completely different risk profile. If you're short puts and the market goes down you suffer a double whammy on both your deltas and your vegas. If the market goes up, both factors work in your favor. If you're short calls and the market goes up, you lose on your deltas but the positive effect of your vegas will partially (or sometimes completely) offset that. If the market goes down you make money on your deltas, but the increased IV will partially offset that. That's why for all practical purposes it's more risky to short otm puts than calls. Sure, if you short puts every month for a million years or short calls every month for a million years, you may come out even in the end. But during our lifetimes, there's a much bigger chance of blowing out your account if you're a put seller than if you're a call seller.