Short Puts vs. Covered Calls: Which Are Better?
07/27/2010 12:01 am EST
Traders beginning to use options will frequently start with covered calls. This options strategy provides the benefits of reduced portfolio volatility, monthly income, and increased risk control. Depending on your options broker, this may be the only options strategy authorized for a new account. These benefits are significant and over the long term can increase portfolio returns. However, it may surprise many investors that the same benefits can be had without increasing risk by selling naked or short puts.
In fact, selling puts against the S&P 500 has been shown to outperform both the returns of the S&P 500 alone or a covered call strategy on the S&P 500 over the long term. Investors will often avoid naked options trading because they believe that the strategy exposes them to unlimited risk, which is theoretically true with a short call, but is not the case with a short put. In fact, the maximum risk in a short put is equal to the price of the stock minus the premium received. That is the same risk you are exposed to in a covered call.
This may seem strange, but consider that when you sell a covered call, you own the stock. If that stock is worth $50 a share and falls to zero, you have lost $50 minus the premium of the call. Conversely if you sold a put and the same stock falls to zero, you will have the option exercised for $50, which (minus the premium for the put you sold) is your maximum risk. It is surprising that these two strategies that seem so different could be so similar from a risk perspective.
Quite often what you are trying to do with a covered call is increase your control over the downside potential of a stock that you own. If you are very concerned about the near term, you may sell a call that is at or slightly in the money. Conversely, if you are very optimistic in the near term, you may sell a call that is out of the money for a smaller premium but more upside potential. A short or naked put can be used in the same way by selling in or out of the money depending on how bullish or bearish you feel.
While many things are similar between the two strategies, one of the advantages of a short put is that the costs are lower. A short put is only one transaction, while a buy-write, or covered call, is two. Additionally, although a short put's upside potential is limited to the premium alone, it usually has more downside protection than a covered call. Although both strategies are bullish, you would normally anticipate that a short put strategy will outperform covered calls in a volatile or down-trending market. That has been true when you compare the CBOE put-write index (PUT) with the CBOE buy-write index (BXM) over the 2008-2009 bear market.
Which strategy is right for you depends on your trading objectives and market outlook. If you need maximum control over your risk, then a short put strategy may be the best choice. If you want more upside potential and are willing to take on more risk, out-of-the-money covered calls are appropriate. This is a great illustration of one of the best things about being an options trader. You have many alternatives and a lot of flexibility to make the right choice for your portfolio.
The video below will walk through a case study that compares covered calls and short puts on a popular indexed ETF.
By John Jagerson of Learning Markets.com