Cash-Secured Puts Vs. Covered Calls
Let us discuss two options strategies a lot of investors may think are similar. Investors are correct to assume these strategies are similar in many aspects, but they are not exactly the same. This article focuses on Cash-Secured Puts and Covered Calls. We define each strategy individually, and then how they are different from each other.
Cash-secured puts is an options strategy where a seller enters a short put position for which he receives cash (or premium). In exchange for that premium however, the seller is obligated to buy the underlying stock should the buyer of the put option (long position) wish to exercise it. Exercising a put option basically means the long put position will sell the stock to the short put position at a predetermined price (strike price). Exercising the put option usually only happens when the underlying stock price drops below the strike price. The short put position can be risky, therefore the strategy should only be implemented by advanced options traders. Cash-securing your position means you set aside enough cash to make sure that you can fulfill this obligation should the option exercise at the strike price. This makes a cash secured put strategy safer than a naked put strategy, where the seller of the put does not set aside enough cash to buy the underlying.
Covered call writing on the other hand, is when you sell a call against a long stock you already own, allowing you to earn premium income in exchange for temporarily forfeiting much of the stock’s upside potential. It means you are willing to sell your long stock at the call’s strike price when “called upon” by an exercise notice. This strategy is best for stockowners that are not hesitant to sell the shares if the stock rises and the calls are assigned.
SIMILARITIES OF CASH-SECURED PUTS & COVERED CALL WRITING
- Some of the similarities between the two include the fact that they have similar profit and loss graphs. You can accomplish similar returns by employing both strategies, with similar risks.
- Secondly, the process for selecting stocks or ETFs for consideration in implementing these strategies is precisely the same on both.
- Lastly, they both require investors to have mastered the skills in selecting stocks as well as selecting options, and managing their position well.
Let’s look at an example where the two strategies can accomplish the same thing.
You believe a stock will decline in value in the short term, but will increase in the long term. You consider both option strategies to protect yourself against a short-term decline.
- The stock’s price is $48.
- The put or call option you consider is at the strike price of $50.
- The put premium is $3.50.
- The call premium is $1.50.
Because of the call-put parity it won’t matter if you implement the secured put strategy or a covered call strategy. In other words, if you short the put while having enough cash to buy the stock at the $50 exercise price, your exposure is the same as if you were to long the stock and short the call option at the same strike price. The P/L graph will look like this:
You must keep in mind that whether you prefer one over the other, there are options with different strike prices that do better in bull markets and there are others that do well in bear markets. Consequently, you must also have an exit plan and know when to rebalance your portfolio so you do not go out of line of your intended risk and exposure. Investors should know ahead of time what they will do under different underlying stock price scenarios.
Do not ever make the mistake of trying to figure it out when the scenario occurs. It pays to plan ahead of time. Some scenarios to think about are what you should do when the stock price turns out much better than you expected. Another one would be what will your course of action be if the strike is in the money as the expiration approaches. What would you do for each scenario? Will you keep holding the option, or sell before the expiry and “roll” the position for next month’s expiry?
Now let’s look at the differences between the two.
DIFFERENCES OF CASH-SECURED PUTS & COVERED CALL WRITING
- A cash-secured put writer typically wants to acquire, via assignment, the underlying stock. The downside here is that a put assignment is not guaranteed. Any investor will miss out on purchasing the stock if the price remains above the strike price throughout the option’s life. The investor will lose out on any upside potential.
- Covered call writers want to earn premium income without taking on additional risk. This also provides an extra cash cushion, equal to the premium income, should the stock price drop. Regardless of the outcome, the premium an investor receives boosts the overall returns of his position. Although, here again the investor may lose out on any upside if the call option gets exercised when the underlying stock’s price is significantly higher than the strike price.
- Put sellers do not collect dividends. They generally receive higher premiums for their short put position when an ex-dividend date comes prior to expiration.
- Covered call writers own the underlying shares. They collect the dividend distribution as long as the shares are owned on the ex-dividend date.
- Put sellers can only generate the premium (one income stream). Compared to selling cash-secured puts, covered call writing is a somewhat more bullish strategy. But this is only the case because of the primary motives for each option strategy discussed above. In terms of the exposure and profit taking potential, both strategies can accomplish similar risk/return objectives.
- Covered call writers make a premium on the option plus the stock’s appreciation if and when an out of the money strike call option is sold. Recap the example discussed earlier: let’s say you bought a stock at $48 and sell the out-of-the money $50-strike call option for $1.50. Let’s say the stock’s price by the time the contract expires, moves up beyond the $50 strike.
You will earn $1.50 per share plus $2 per share due to the price appreciation from $48 to $50. You gain $3.50 per contract, which includes two income streams in the same month with the same stock.
- Cash-secured puts’ first step is to place the appropriate amount of cash into the brokerage account for a possible future stock transaction with a put buyer. Then sell the put option. There’s one transaction (short put).
- The first step for covered call writers is to place money into the brokerage account and buy the underlying stock. This is what makes the strategy covered or protected. You own the shares before selling the call option. There’s two transactions (long stock, short call).
- A price-sensitive investor usually sells cash-secured puts. He is slightly bearish to neutral on the market especially when it becomes volatile. If the expectations go well, this strategy allows investors to buy the stock at a price below its current market value.
- Covered call writers generally look for a steady or slightly rising stock price. The type of stock they select also dictates what they do based on overall market assessment and personal risk tolerance. So if we are bullish on the overall market, we are more likely to sell an out-of- the-money call option.
Use in Self Directed IRAs
- Selling cash-secured puts is allowed only by some brokers.
- Covered call writing is allowed and regulated by FINRA.
Cost to Close when Stock Declines
- The costs involved in closing out the cash-secured put position are higher than the original premium generated if the price declines beyond the breakeven point.
- In covered call writing, the price of the option declines when the price of the stock declines. So you earn money on the call option but lose on the declining stock price.
- The potential profit is limited to the premium received with cash-secured puts. The potential loss on the other hand is limited to the strike price minus the premium received. However, the profit you gain is attractive with a cash-secured put if an assignment occurs and the stock’s price begins rising.
- As for covered call writing, you gain more when you have a good exit strategy for a stock. Your profit or loss will largely depend on whether you prefer to keep the stock longer or not. Your profit is limited to the strike price less the purchasing price, plus the premium you receive for selling the call. Your potential loss is biggest on the long stock position.
Although covered call and cash-secured puts may have the same risk-reward profile, each strategy boasts of various advantages to investors with different risk appetites.
With cash-secured puts, usually the main intent for the investor is to acquire the underlying stock at a cheaper price. Even if it may hit near-term lows, as long as the put writers expect an assignment and are comfortable with the stock’s risks, their investment is in great shape. The only time that it may largely affect the investor is when the underlying stock becomes too volatile and falls lower than initially anticipated price levels, or in extreme cases, drops to zero.
As for the covered call strategy, take into account that you are still exposed to the downside of the stock’s potential decline and you may have restrictions on selling the stock when you have a short call position. All covered call investors need to monitor the stock for possible early assignment.
Overall, all else being equal, it may be more advantageous to implement the cash-secured put position given that you will decrease your brokerage commissions since there’s only one transaction involved, instead of two in the covered call strategy. However, if you already own the underlying stock and wish to generate premium income, a covered call position may be more appropriate.