No Free Lunch: Long Calls vs. Married Puts

Heh… that’s right, there is no free lunch.

BTW, the reward side is better for a married put than it is for a straight call as well. Check the numbers using my example from the video: If ESRX goes to $85, the $75 call option purchased for $8.30 will now be worth $10.00. That’s a gain of $1.70…On the other hand, the stock only portion (the put will expire worthless) of the married put will be worth $85. Since the married put was purchased for a total investment of $82.35, the dollar amount gain is $2.65!

Now here’s where it all gets sticky: The one call contract returned $1.70, while the one put contract plus stock returned the higher dollar amount of $2.65 on the same move in the stock, yes. But another thing the critics will point out is that while the married put DID bring in more dollars… the amount it brought in AS A PERCENT was different.

I’ll concede that point. But if “as a percent” is how we measure things, then by all means let’s keep it even. Let’s apply this test to losers as well as winners. Shall we?

First, the call: a $1.70 win on $8.30 invested is a 20.98% gain. Cool.

The married put: a $2.65 win on an $82.35 investment is only a 3.22% gain. NOT as cool, even though the dollar amount won IS higher, it’s not as big percent-wise.

Here’s where the rubber meets the road: how these bad boys handle losses.

If ESRX goes to $80 … the loss will be $3.30 with the long call.

A $3.30 loss will be pretty devastating in relation to the money invested: 39.76%.

On the other hand, with the stock at $80 the married put will lose $2.35… again, a smaller dollar amount… and MUCH smaller when the percent loss is considered. $2.35 is only 2.85%.

The loudest argument I hear from the critics is that a long call is more EFFICIENT because less capital is used. I’ll go along with that… it’s an efficient way to over-leverage oneself.

Another claim is that you can trade with less capital. My contention is that using a married put FILTERS what you trade. In other words, if you cannot afford to buy the stock and the put, its likely that you shouldn’t be trading the long call either.

Finally, the Martingale principle: the percentage gain one must make to offset losses rises exponentially as a function OF the loss.

The 2.85% loss above must be offset by a mere 2.93% gain. But the 39.76% loss has to be offset by a 66% win… harder to come by, for certain.

That’s why I’m saying that it’s so important to pay attention to position sizing. If we say, “A long call is more efficient.. because you can take an IDENTICAL position with MUCH LESS CAPITAL…”

…then that’s misleading. If we properly state, “A long call is the same as a married put IF AND ONLY IF you deposit a commensurate amount into an interest bearing account”, why then we’ll be telling the WHOLE truth. And we’ll keep folks that are trading with $2k in capital from believing they’re in the same position as me when they buy one call contract and I buy one married put.

Okay, enough soapboxing. I just want to bring position sizing into the picture rather than leave it out and cry, “efficiency, equivalency” and other nonsense.