Covered Calls Vs Cash Puts (see Matt's Favorite)
Covered Calls Vs Cash Puts. If you are an option seller, then you may be wondering what the best way to sell options is. There are a few different strategies that you can use, but one of the most profitable is selling covered calls. In this advanced session, we will explain why covered calls pay more than cash-secured puts and how you can start using this strategy to make more money for your portfolio!
Importance of Selling Options
Option buying is extremely dangerous because of the main factor of time decay. Time decay is the natural enemy with trading options because it erodes the value of their options contracts over time. I am sure you have seen all the wallstreetbets screenshots of hundreds of thousands of dollars when an option expires worthless. This is the danger of short expiration options with extremely high time decay. BUT what you haven't realized is on the other side of that option going to zero is a person making money. That person can easily be you if you understand the power of option selling. This is why it is so important to sell options instead of buying them. When you sell an option, you are taking in a premium and giving up the chance for unlimited profit potential. This makes selling options a much more conservative strategy than buying options. This also gives anyone holding the underlying asset or cash the ability to generate income instantly.
Risks of Selling Options
There are a few risks that come with selling options on a specific stock. The first is the risk of assignment. This happens when the option buyer decides to exercise their option and buy (put options) or sell (calls options) your 100 shares per contract at the agreed-upon strike price. This can happen at any time until the expiration date, so you need to be prepared for it. The second risk is called a margin call. This happens when the option seller's account falls below the required margin level set by their brokerage. This can happen if the underlying stock moves against them or if they have sold too many contracts relative to their account size.
Cash Secured Puts Explained
Now that we have talked about the risks of selling options, let's talk about how cash-secured puts work. As the name suggests, this is a strategy where you put up 100% of the cash required to buy the 100 shares at the strike price. The goal could be to acquire the underlying security at a discount or for the option to expire worthless. You do this by selling a put option and then having enough cash as collateral in your account in case you need to buy the shares during the assignment by the specified period.
There are three scenarios that can happen once you sell a cash-secured put:
1) Assignment: If the buyer of the put option decides to exercise their right to sell your shares, then you are obligated to buy them at the agreed-upon strike price. This is not a bad scenario because you will keep the premium from selling the options and be able to buy your shares discount.
2) ITM Expiration: If the underlying stock closes below the strike price of the put option on the expiration date, then you will be assigned and have to buy 100 shares per option contract typically at a discount. This is ALSO not a bad scenario because you will keep the premium from selling the options and also get to keep the discount in the underlying stock.
3) OTM Expiration: If the underlying stock rises above the strike price of the call option on the expiration date, then you will not be assigned and your cash collateral will be freed up the following day. This is also a good scenario because you keep the premium from selling the options and get to keep your precious shares on the trade.
How to Sell Options: Cash-Secured Puts
All options sold will have a negative number when you go to input the trade. This means you are selling the option and will need the capital or stock as collateral. Let's further breakdown this trade below:
Option Type: Cash-secured puts
Number of Contracts: 16
Strike price: $11
Capital Required: $11 x 16 x 100 = $17,600
Premium: $581 (minus commissions)
Return on capital: 3%
Pick up stock price: $10.63
In this scenario, the option sellers have a 100% chance of collecting the premium but the stock's price could fall well beneath the pick up price causing the seller to lose money. It is important to understand the risk tolerance and the capital required so the trader doesn't enter a margin call with their brokerage service.
Covered Calls Explained
Now that we have talked about cash secured puts, let's talk about how to sell covered call options. The most common way of selling a call option is through a strategy called covered calls. The goal could be to sell the underlying security at a premium or for the option to expire worthless. This is where you sell a call option against 100 shares of stock that you already own.
There are three scenarios that can happen once selling a call option:
1) Assignment: If the buyer of the call option decides to exercise their right to buy your shares, then you are obligated to sell them at the agreed-upon specified strike price. This is not a bad scenario because you will keep the premium from selling the options and be able to sell your stock at a profit.
2) ITM Expiration: If the underlying stock price rises above the strike price of the call option on the expiration date, then you will be assigned and have to sell your shares at a profit. This is ALSO not a bad scenario because you will keep the premium from selling calls and also get to keep the appreciation in the underlying stock.
3) OTM Expiration: If the underlying stock price falls below the strike price of the call option on the expiration date, then you will not be assigned and your shares will remain unchanged. These options are considered out of the money, therefore the price of the option will have no value at the time of expiration. This is also a good scenario because you keep the premium from selling calls and get to keep your precious shares on the trade.
Covered Calls Strike Price Example
All options sold will have a negative number when you go to input the trade. This means you are selling the option and will need the capital or stock as collateral. Let's further breakdown this trade below:
Option Type: Covered Call Options
Number of Contracts: 16
Strike price: $13.5
Shares required: 16,000
Capital Required: 16 x 100 x 12.22 = $20,000
Premium: $741 (minus commissions)
Return on capital: 3.7%
Return if assigned: 14%
In this scenario, the option sellers have a 100% chance of collecting the premium but with covered call options, there is a chance to make a profit from the run to the strike price. The difference between the strike price and the current price can be added to the premium amount as a possible total gain from the trade. It is important to understand the number of shares needed so the trader doesn't enter a naked call option which can result in a margin call. This could present an unlimited risk scenario and be incredibly dangerous for call sellers.
Covered Calls vs Cash-Secured Puts
At this point in the blog, you probably can already tell why covered call options can help maximize portfolios even faster. The main difference is due to the stock appreciation. When you sell an option you have a 100% chance of collecting the premium, which will not change for covered call options and cash-secured puts. So from a premium perspective, they are equal. BUT covered calls have the ability to profit from stock appreciation as well. Cash secured puts only require collateral to buy the stock, so the option seller will never make money from the stock going up and have a theoretical loss if the stock goes down. When you own the stock and sell an option, you can make money off the appreciation which makes a covered call option the better choice when deciding which type of option to sell.
Cheat Guide for Underlying Stock, Covered Calls, and Cash Secured Puts
From my many years selling options, I have learned the hard way when if they perform poorly and when they can allow my account to blossom like a butterfly. Below is a cheat guide based on when to use what. Let's break it down:
Stock Uptrends: This is where covered calls and just naked stock will always have the most appreciation. Cash secured puts will lag in this scenario and not allow traders to maximize their portfolios. This is based on the fact that stock moving 10-30% in one month will beat the returns of most options sold. In fact, selling options at all in a major uptrend will greatly limit the gains possible.
Stock Downtrends: This is where covered calls and just naked stock will do the most damage to your portfolio. Cash secured puts will not be as painful on portfolios during this time because you do not own the stock. Owning the stock and holding a covered call allows you to lose money from the stock losses in this scenario which can be quite large and greater than the premium. This is based on the fact that stock moving down 10-30% in one month will not be able to be made up for by the option premiums collected. In fact, selling options or owning the stock at all in a major downtrend will greatly increase the losses.
Stock Trends Sideways: This is where covered calls will always have the most benefits. Cash secured puts will lag in this scenario and not allow traders to maximize their portfolios. Because the stock is not in a major uptrend of a downtrend, a trader will have an easier time selling options and avoiding assignments. Or trading the true wheel without having huge differences in cost basis for both legs of the options. The appreciation of the stock during this consolidation will always allow covered calls seller to beat the returns from a cash-secured put. That is why it is still preferred in this scenario.
Covered Calls vs Cash-Secured Puts
Now that we know about some of the risks associated with selling options, let's compare a covered call option to a cash-secured put option. The main difference between these two strategies is that with a covered call option, you own the underlying stock and are selling the option against it. With a cash-secured put, you do not own the underlying stock and are simply hoping that the price of the stock falls below your strike price so that you can buy it at a discount or just collect the premium if it stays above.
As you can see, there are a few big advantages to selling covered calls instead of cash-secured puts. The first is that you make more money. Covered calls pay more than cash-secured puts because the option seller has the chance to keep the premium if the stock stays below the strike price
Covered Calls vs Cash-Secured Puts Example
As we showed earlier, covered calls were able to return much more on the amount of capital required compared to cash-secured puts only if the stock appreciates. In the chart below, you can see just how big this difference is. If you sold a put at the $11 strike the maximum you can make regardless of stock direction is 2.75%. With a covered call option, you would be able to return 14.5% if the stock ended up running right into the strike price sold. The covered call would pay a minimum of 3.8% regardless of the stock direction. All this means is if the stock runs hard, it would take about 4-5 weeks of cash-secured puts selling to make up for the one gain from this covered call. In a bullish run, the risk to reward may be for the covered call seller!
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