As a companion piece to his options article on bull markets from last week, Alan Ellman, of TheBlueCollarInvestor.com, compares and contrasts covered call writing versus cash-secured put selling in bear markets.
Our stock options strategies, whether writing covered calls or selling cash-secured puts requires us to make an overall market assessment before entering any trades. In last week’s article, we evaluated bull market scenarios. In this week’s blog, we will examine bear market environments. When selling covered calls we would favor in-the-money strikes to gain additional downside protection should share price decline. When selling cash-secured puts, we would favor selling out-of-the money puts (lower than the current market value of the stock). In today’s article, I will use the options chain for Facebook, Inc. (FB) to demonstrate the calculations for potential covered call writing and put-selling trades. First, the options chain from May, 2014 where I have highlighted a row in pink:
Facebook options chain
Click to Enlarge
Bear Market Trade and Calculations for Covered Call Writing
We favor in-the-money strikes (ITM), which will generate time value returns that meet our goals along with downside protection of the option profit (different from breakeven). The deeper in-the-money we go, the greater our protection. With FB trading @ $60.84, we will view the $57.50 ITM strike:
- Call premium = $5.45
- Intrinsic value of the premium = $3.34
- Time value of the premium = $2.11
- Initial profit = $211/$5750 per contract = 3.7% (the intrinsic value “buys down” our cost basis to the strike price)
- Annualized return = 31%
- Downside protection of the 3.7% = $3.34/$60.84 = 5.5%
- This means that we are guaranteed a 6-week return of 3.7% as long as share value does not decline by more than 5.5% by expiration Friday
- Breakeven = $60.84 – $5.45 = $55.39
Bear Market Trade and Calculations for Selling Cash-Secured Puts
We favor out-of-the-money strikes, which will generate more protection against share decline and less likelihood for share assignment (shares ‘put’ or sold to us). The deeper out-of-the-money we go, the greater our protection. With FB trading @ $60.84, we will view the $57.50 ITM strike. Note that we are using the same strike as for writing calls where the $57.50 strike is considered in-the-money. For selling puts, that same strike is considered out-of-the-money:
- Put premium = $2.13
- Initial profit = $213/$5537 per contract = 3.8% (put premium decreases our cost basis)
- Annualized return = 33%
- Downside protection of the 3.8% = $3.34/$60.84 = 5.5%
- This means that we are guaranteed a 6-week return of 3.8% as long as share value does not decline by more than 5.5% by expiration Friday
- Breakeven = $57.50 – $2.13 = $55.37
Summary
In bear market environments, we favor in-the-money call options for covered call writing and out-of-the-money put options when selling cash-secured puts. The returns will be similar when going a like amount in- and out-of-the-money.
By Alan Ellman of TheBlueCollarInvestor.com
