While the risk-reward profiles for covered call writing and put selling are similar, there are differences, so Alan Ellman, of TheBlueCollarInvestor.com, lays out the definitions for each as well as the pros and cons and when he prefers one over the other.
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.
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|pagebreak|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)
Click to Enlarge
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.
By Alan Ellman of TheBlueCollarInvestor.com
