Are Cash-Secured Puts Better than Covered Calls?

...
Jesse Anderson

Many investors approaching retirement seek strategies that provide consistent income while managing risk. While bonds and dividend-paying stocks are two common choices, low-risk options strategies like covered calls and cash-secured puts are a popular alternative that provide an extra boost of income.

In this article, we’ll dive deep into the world of cash-secured puts and covered calls, comparing their benefits, risks, and ideal use cases. By the end, you’ll have a clearer understanding of how these strategies work and whether you should use them.

How Cash-Secured Puts Work

Cash-secured puts involve selling (writing) a put option on a stock while simultaneously setting aside enough cash to cover the potential purchase of shares at the strike price.

Here’s how it works:

  1. You sell a put option on a stock that you’re willing to buy.
  2. You receive a premium (the option’s price) upfront.
  3. You set aside cash equal to the strike price multiplied by 100 (since each option contract represents 100 shares).

If the stock price remains above the strike price at expiration, the option expires worthless, and you keep the premium. This is effectively a “yield” on the cash you set aside. If the stock price falls below the strike price, you may be obligated to buy the shares at the strike price. But that’s still at a discount to the original stock price.

Let’s take a look at an example:

Apple is trading at $220 per share with an out-of-the-money put option trading for $0.32 and a strike price of $200. If you’re considering purchasing Apple stock anyway, you might sell the put option, receive $32 and commit to owning the stock at $200 if it falls. And, in the process, you’re earning a 0.16% return—or 1.94% annualized income.

There are a few caveats:

  1. Opportunity cost – The cash you set aside can’t be used for other investments while the option is active, so you could miss out on a good opportunity.
  2. Limited upside – The maximum profit is capped at the premium you receive.
  3. Potential for loss – If the stock price falls significantly below the strike price, you’re obligated to buy shares at above-market prices.
  4. Assignment risk – The option can be exercised any time before expiration, potentially forcing you to buy the shares unexpectedly.

How Covered Calls Work

Covered calls are another popular options strategy to generate income. Rather than selling a put option, the strategy involves selling (writing) a call option against an existing long stock position, providing extra income and a buffer against downside.

Here’s how it works:

  1. You own at least 100 shares of a stock.
  2. You sell a call option on that stock with a strike price above the current market price.
  3. You receive a premium (the option’s price) upfront.

If the stock price remains below the strike price at expiration, the option expires worthless, and you keep both the premium and your shares. You’ve effectively earned an extra “dividend” on the stock. If the stock price rises above the strike price, you may be obligated to sell your shares at the strike price.

Using the same Apple example, suppose that you already own 100 shares at $220 per share. You could write a covered call with a strike price of $230 and receive $1.62 in income. That’s a 0.74% return—or 9.25% annualized—but you will only gain a maximum of $11.62 per share, sacrificing any additional upside.

Again, there are a few caveats:

  1. Opportunity cost – If the stock price rises significantly above the strike price, you miss out on the gains since you’re obligated to sell at the strike price.
  2. Assignment risk – The option can be exercised at any time before expiration, so you could end up unexpectedly selling your shares.

Comparing the Strategies

Now that we’ve explored both cash-secured puts and covered calls, let’s compare the strategies and help you determine the best option for your portfolio.

Maximizing Income

Cash-secured puts generally offer higher premiums, especially in volatile markets or for stocks with high implied volatility. But, while covered call premiums are slightly lower, they offer some upside potential in the price of the stock.

Risk Profile

The risk profile for both trades are nearly identical.  In both cases, the biggest risk is the stock price falling significantly.  On your covered call, you experience large losses on your stock shares.  For a cash-secured put, any decline beyond the strike price will lead to owning a stock at a higher price than the current market value. Also, for both trades, you miss out on some gains when a stock price rises significantly.  You trade this opportunity cost for the premium you collect upfront for the sale of each option.

Capital Requirements

Cash-secured puts are cheaper than covered calls since you’re setting aside cash to buy 100 shares at a below-market price. Meanwhile, covered calls require owning 100 shares at the current market price.

Market Outlook

Cash-secured puts and covered calls are both appropriate for flat to moderately bullish markets.

What’s Right for You?

Deciding between cash-secured puts and covered calls depends on various factors, including market conditions, your investment goals, and personal risk tolerance.

If you have an existing stock portfolio and are willing to trade-off some upside potential for income, then covered calls may be the perfect complement to your portfolio. Or if you want to make the same trade-off for a little extra downside protection, the income from covered calls can provide a buffer during modest declines.

If you are looking to add stocks to your portfolio, you might consider cash-secured puts to earn extra income while waiting for prices to fall to your target levels.

You can also use both strategies in what’s known as the “option wheel.” Using this strategy, you would write cash-secured puts until you own a stock and then write covered calls against the stock until you’re forced to sell it. The result is a “wheel” where you’re constantly earning income from options.

You can find opportunities using options screeners like optionDash. After defining your moneyness and expiration, you can see a list of opportunities that you can sort by if-called return, annualized return, downside protection, and other attributes.

Covered Calls

optionDash provides detailed fundamental and technical analysis tools to help you make a more informed decision than looking at options prices alone. Source: optionDash

In addition, optionDash makes it easy to assess the risk of each opportunity at a glance with its proprietary scoring system. The platform calculates a value, quality, and trend score for each stock while highlighting upcoming earnings dates and other catalysts that could impact your decision and the trade’s outcome.

And finally, you can create watchlists to track your favorite covered call or cash-secured put stocks in one spot while accessing ideas lists from others.

The Bottom Line

In the debate between cash-secured puts and covered calls, there’s no universal “right answer.” Both approaches have their merits and can be valuable tools in your arsenal. The choice between them depends on your individual circumstances, market outlook, and investment goals—and tools like optionDash can help you make informed decisions.

If you’re looking for some help getting started, consider taking Snider Advisors’ e-courses covering key concepts when using cash-secured puts and covered calls. They will introduce you to the Snider Investment Method and show you how it can help simplify critical decisions like which stocks to own, what strike prices to choose, and how to handle your positions at expiration.

Posted in Covered Calls | Tagged , ,