When studying option trading basics we learn that to be in a “covered” position we must first purchase the stock before selling the option for the strategy of covered call writing. Some investors will execute both parts of the trade by using a buy-write combination form and using a net debit order. Another approach to this great strategy is to plan to purchase the stock at a discount while at the same time still generating a monthly cash flow. This involves selling a put option which gives the option holder the right, but not the obligation, to sell us the stock at a price that we determine (the strike price), by a date that we determine (the expiration date) and in return for undertaking this obligation we receive a cash premium that the market determines.
Some books and courses on options suggest that when you sell a covered call option, you are investing more money but getting similar returns as when you sell a put option. Therefore, the latter makes much more sense than the former. I must respectfully disagree. Both are viable investment options but they are not the same. First some background information.
Definitions:
Covered call options– We buy a stock and sell a call option on that equity, giving the right, but not the obligation, to the option buyer to purchase the stock from us at a specified price by a specified date. The time value of the option generates a premium, our initial profit. For example, we buy a stock for $30 and sell the $30 call option, generating a return of $150 per contract.
(Naked) Put options– Here we are selling the right, but not the obligation, for the buyer of the put to sell a stock to us, at a specified price, by a specified date. In return for undertaking this obligation, we also receive a premium. For example, a stock is trading at $30 per share and we sell a $30 put and receive a return of $150 per contract. The returns in these scenarios are usually pretty similar and if the put is exercised, we are required to buy the stock for the same $30, the call seller paid in the covered call example. So what’s the difference and why should we have to buy the stock and lay out all that cash for the covered call position? Note: The put seller buys the stock at the strike less what he/she received from the put sale…some traders look at this as a way to get a stock you want to own at a discount.
Cash-secured put– When a brokerage company requires us to have the cash in our accounts to purchase the shares we are obligated to buy, it is now known as a cash-secured rather than a naked put. Some investors will enter a covered call position by first selling a cash-secured put and if exercised, then sell a call on the stock put to us. This is one area I plan to address in an upcoming book.
Here are the reasons I prefer covered call writing to naked put selling in normal market conditions:
- Many brokerages want the assurance to know that you have the ability to purchase the shares you are obligated to buy when selling the put. Therefore, they will require you to have an adequate amount of cash in your account to cover such an event. You will then have sold a cash-secured put and set aside the same amount of cash as the covered call seller.
- The seller of a covered call captures all dividends distributed by the underlying corporation, the put seller does not. We’re not talking about a huge windfall here, but the cash is better in our pockets than someone else’s. This profit is partially compensated for by higher put premiums prior to dividend distribution when selling puts.
- Selling covered calls allows the investor more flexibility. The most profit a put seller can generate is the premium on the option sale. A covered call writer can profit from the option premium PLUS additional share appreciation if an out-of-the-money strike is sold. That choice is available to the covered call writer but not to the put seller.
- Early assignment is not an issue for covered call writers because the option premium is not affected and possible additional upside appreciation is incorporated into your profits if an O-T-M strike was sold. For put sellers, early assignment could be a disaster. Imagine a stock gapping down after unexpected negative news, and the stock “put” to us at the $30 strike. The stock is plummeting and heading for the teens! The put seller wants to sell the stock before it loses more ground but perhaps the shares haven’t even hit his account yet. He may have to wait until the next day to sell the shares. One way of getting around this issue is to sell the shares short (selling before actually owning them). The problem with this solution is that average Blue Collar Investors will have a difficult time getting “shorting privileges” from their brokerage firm and may lack the sophistication necessary to manage such situations. Besides, who needs the headaches?
- Those interested in option investing in tax sheltered accounts, will have an easier time establishing such accounts using covered call writing than any other form of options trading.
Real Life Example: RAX as of 8-27-12:
I have randomly selected, RAX, a stock on the BCI Premium Watch List as of 8-27-12. At the time, this equity was trading @ $59 so I have highlighted the following options:
- $55 in-the-money call option (yellow field)
- $55 out-of-the-money put option (green field)
The Mathematics:
For the $55 call option we generate a premium of $5.70, $4 of which is intrinsic value (not profit). The time value (our initial profit) is $1.70 and we use the intrinsic value to “buy down” our cost basis to $55. Our initial profit, therefore, is:
$170/$5500 = 3.1%: This means that the 3.1% initial return is guaranteed as long as the share price remains at or above $55.
For the $55 put option, if cash-secured, requires us to have $5500 in our account in case of exercise. The return is therefore:
$180/$5500 = 3.3%
Exercise of the put will occur if the price drops below $55 and we then have the choice of writing a call on the “discounted” stock. As you can see in normal and bullish market environments, we lose the ability to profit from share appreciation. Another consideration for many retail investors is the requirement to look at trades from two perspectives…in-the-money and out-of-the-money. This may or may not be an issue.
Conclusion:
There are many ways to make a profit in the stock market and certainly selling puts is one of them. I would give stronger consideration to put selling in bearish market environments. The risk-reward profiles for covered call writing and put selling are similar but there are differences. Each investor must be well-informed about all strategies and approaches before deciding on which road to take with his (her) hard-earned money.
Upcoming live events:
September 14th, 2012: Forex and Options Traders Expo/ Paris Hotel, Las Vegas. Register FREE on this site
November 10th, 2012: Chicago Chapter AAII/ DePaul Center, Chicago
January 19th, 2013: Milwaukee Chapter AAII/Annual Winter Retreat Meeting
April 20th, 2013: Atlanta Options Investor Club/ Georgia State University, Alpharetta, Georgia
September 17th, 2013: Philadelphia Chapter AAII/ Plymouth Meeting, Pennsylvania
Market tone:
- Once again, this week’s economic reports suggested an economy growing at a sluggish pace, but growing nonetheless:
- Fed Chairman Ben Bernanke stated “The Federal Reserve will provide additional policy accommodation as needed to promote a stronger economic recovery and sustained improvement in labor market conditions in context of price stability”
- Personal income rose by 0.3% in July according to the U.S. Bureau of Economic Analysis (BEA)
- Consumer spending increased in July to a seasonally adjusted 0.4%, the highest rate since February
- The Consumer Confidence Index fell in August to 60.6, its lowest level since November, due to business and employment prospects
- GDP (a measure of economic output) grew at a 1.7% annual rate in the second quarter, as expected
- New factory orders for manufactured goods rose by 2.8% in July after a decline of 0.5% in June, better than the 1.8% anticipated
For the week, the S&P 500 decreased by 0.3% for a year-to-date return of 13.5%, including dividends.
Summary:
IBD: Confirmed uptrend
BCI: Moderately bullish slightly favoring out-of-the-money strikes
Wishing you and your family a happy, healthy and safe holiday weekend,
Alan and the BCI team ([email protected])
Premium Members,
The Weekly Report for 08-31-12 has been uploaded to the Premium Member website and is available for download.
Also, be sure to check out the latest BCI Training Videos and “Ask Alan” segments. You can view them at The Blue Collar YouTube Channel. For your convenience, the BCI YouTube Channel link is:
http://www.youtube.com/user/BlueCollarInvestor
Best,
Barry and The BCI Team
Alan,
Would you use the same list of stocks you provide for call selling as you would use for put selling? Thanks for this informative article.
Kathy
Kathy,
Yes, absolutely the same list with the same criteria. Even though put selling is more of a conservative strategy we still want our shares to appreciatem or at least stay the same price. We, don’t, for example, want a $29 stock put to us for $30.
Alan
Alan,
1. Covered calls and 100% cash-secured puts are synthetically equivalent strategies when done at the same strike price and for the same expiration date.
2. Dividend payments are factored into the price of all options, so a stock with an upcoming ex-div will have a higher implied volatility for the Puts than for the comparable Calls. It’s true: “There is no such thing as a free lunch.”
Jeff,
Good point on the IV of puts. However, I do believe that every discussion of put selling vs covered call writing should at least mention the dividend aspect and for that matter the fact that it would cost more to close the short put position if necessary. Both strategies have their merits but they are not precisely the same.
Alan
Alan,
Another disadvantage of put selling besides the ones you listed is that it requires a higher level of trading approval by your brokerage.
Fred
Fred,
Excellent point and one that I only briefly alluded to in my article. Many brokerages consider (cash-secured) put selling a higher risk than covered call writing and therefore require a higher level of options trading approval. Naked put selling is at an even higher level of approval. The levels may vary from brokerage to brokerage but I have captured a typical example in the screenshot below. The yellow field shows covered call writing in the lowest level of approval (least risky) and the green field shows cash-secured puts in the next higher level. CLICK ON IMAGE TO ENLARGE AND USE THE BACK ARROW TO RETURN TO THIS BLOG:
Alan
Alan,
In this chart I see the term “covered put”. How is this different from a cash secured put? thanks.
Amy
Amy,
With a cash-secured put, the cash is in our account to purchase the underlying stock if “put” to us. A covered put option is an option sold short after having sold the stock short (borrowing it from the broker). If the short put is exercised and the seller is required to buy the stock, that stock will be used to “cover” the short position in the stock. This is Not something part of the BCI methodology.
Alan
Why do some brokers consider a cover put less risky than a cash-secured put? The investor is borrowing money and paying interest on the loan by selling a stock short and this is considered less risky and/or easier for a novice to do than just having enough cash in the account to buy a stock on a specific date and at a preset price. The logic of this is not obvious to me.
Steve,
I’m as mystified as you are on this one. I haven’t surveyed the different brokerages to see what percentage view covered puts less risky than cash-secured puts but I must intuitively disagree with those who do. Although covered puts to generate extra premium on short positions, it is a risky trade in my view because there is no limit to how much you can lose if the price of the stock rises above the breakeven (put premium + price of underlying @ initiation).
A call to a brokerage may or may not get you a satisfactory response.
Alan
One more related item as to why selling cash-secured puts requires a higher trading level than selling covered calls: I spoke with a former options market-maker and It appears that the consensus on the higher required level of expertise is generally because put positions (and even short positions) are considered conceptually tougher to understand.
Alan
Alan, this is a good topic and I agree with you that put and call selling are not precisely the same but I think about it a little differently. If you disagree with the following, I’ll look forward to your thoughts.
As background, I think your 5 bullet points are essentially the same for the two approaches.
1) Amount of cash tied up is the same.
2) Due to differences in IV, the dividend may be psychologically better but is the same financially.
3) This seems the same also. In your Rax example, what if you sold the $65 OTM options. For the call you collect $1 plus could get $6 of stock appreciation. For the put, you collect $6.90.
4) I think the key point here is what happens if the stock price gaps down significantly. Don’t you loose essentially the same amount either way?
To me, the most important difference between the two is whether the stock price is near support or resistance. If you’re getting ready to sell an option and the stock price has been moving down and is near support, you’re going to get a better premium for the put. If on the other hand, the stock price has been moving up and is near resistance, you’ll get a better premium for selling the call. If it’s true that the four points above are essentially the same, then I would think whether the stock is at support or resistance would be the controlling factor for whether the call or put is better.
Thoughts?
Steve
Steve,
Very good and thoughtful comments. As I suspect you surmise, the answer to your question #4 is YES.
Your thoughts in the last paragraph are appealing; but in practice very difficult to exploit. There is sometimes a very slight temporary advantage of Puts vs. Calls or vice versa, but it is normally so minor that it is very difficult to take advantage of. The reason for this is Put/Call parity. Without this parity, there would be a substantial arbitrage opportunity (a free lunch so to speak) that sophisticated high-frequency computerized models could exploit for substantial risk-free profits.
Jeff
I agree with Alan and the above commentators that the two strategies are quite similar but have nuances that differ. My (minor) concern is that if assignment happened during a particularly severe downturn and the put writer has second thoughts about owning the stock at the strike price, the delay between early assignment, notification, and the shares hitting the account means that the stock could fall further before the investor can act to limit losses. Perhaps that’s why brokerages classify them in different levels of trading requirements. Stimulating subject.
Stan
Jeff, as I think about it, it probably matters if you’re doing the trade as a one-month buy-write or using a stock you want to hold for a few months.
For example, if you want to hold a dividend paying stock and add to the income stream, then you probably want to sell OTM and have it expire worthless. Let’s say it’s bouncing back-and-forth between $90 and $100, at $100 you’d want to sell the $100 or $105 call and at $90 you’d want to sell the $85 or $90 put.
If on the other hand, you’re following Alan’s method and doing it as a one-month trade on expiration Friday, then it probably doesn’t make much difference for the reason you cite.
Steve
I have an E-trade account.
Covered calls- level 1
Cash secured puts- level 2
FWIW
Irene
Alan,
Do you have the same option liquidity requirements for puts as for calls? Thanks.
Jorge
Jorge,
Yes, precisely the same…100 contracts of open interest and/or a bid-ask spread of $0.30 or less.
Alan
To our members:
I hope you had a wondeful holiday wekend. I spent the last two days with family and now it’s back to work. This week I’m putting the finishing touches on my Las Vegas presentation (looking forward to meeting many of you there) and will catch up with on and off-site contacts over the next few days.
Alan
Alan, after having read through your encyclopaedia book there are some things I needed to ask before making decisions from the ESOC calculator,etc.
1. When you go through the IBD 50 list then approximately how many stocks on average are you normally left with for the technical analysis of charts?, also how many usually left with before and then after the calculation of option returns.(if not using premium report)?
2. When using the multiple tab on the ESOC, then if I had already made a decision on what the market environment is like(eg. quite favourable – so go with OTM options), then would I even need to have the other different strilke prices shown with it.(eg. ITM options)?
3. As you have said to use either the rolling out or the rolling out and up strategy (if price ITM at expiration) depending on how positive the share chart is,etc,- then why would I even need to compare the returns(of these 2 situations) on the ‘what now’ tab of the ESOC?
That’s all I don’t understand yet when making decisions on what stocks to use. Thanks
Adrian,
Let me premise my responses by saying that since the IBD 100 became the IBD 50, it is important to screen additional stocks in order to develop a quality watch list of 40-60 equities. The BCI team screens over 3000 stocks each week. It certainly is NOT necessary to screen that many if you are doing the legwork yourself but the IBD 50, although critical, is not enough. My responses:
1- If you follow the BCI methodology, approximately half of the IBD 50 stocks will be eliminated by the time you get to the technical screens. Last week, 18 of the IBD 50 stocks survived our strict screens and “earned” their way onto our running list. 24 stocks were eliminated prior to technical analysis and 8 more after technical analysis.
2- If you are extremely bullish and opt for only OTM strikes, there is no need to calculate ITM strikes. Each of us have our own risk-tolerance. I am a conservative investor and rarely in 100% OTM strikes. It’s important to know our own comfort level and how we would react if some of your positions turned against us.
3- Rolling out and up is a more bullish position than simply rolling out. It allows us to take advantage of share appreciation either past or present. When you roll out it is always to an ITM strike. Rolling out and up can be to an ITM, ATM or OTM strike. This is an important concept to master. See pages 280-292 of “Encyclopedia…” for detailed information.
Alan
Running list stocks in the news: HAIN:
On August 22nd, HAIN (provider of natural food and personal care products) reported a positive earnings surprise for the 7th consecutive quarter, averaging a 6% surprise. Revenues increased by 22% year-to-year. Long term EPS growth stands @ 15% above its industry peers. Our premium running list shows an industry rank of “A” and a beta of 0.78.
Alan