Comparing Covered Call Writing And Selling Cash-Secured Puts
Dr. Alan Ellman | Dec 11, 2016 12:51AM ET
An accepted myth is that covered call writing and selling cash-secured puts are precisely the same strategy. The reason this statement is generally accepted by many investors, is that they have the same risk-reward profiles or profit and loss graphs :
In this article, other similarities will be discussed, as well as some distinct differences between the two strategies that will debunk the myth that they are precisely the same strategy.
More similarities
Both leverage underlying securities to generate cash flow
The screening process and watch lists are the same
Both require the same skill set
- Stock selection
- Option selection
- Position management
Differences
Dividends
Covered call writers (share owners) collect corporate dividends, put-sellers do not. However, due to put-call parity , put-sellers tend to generate a higher premium when an ex-dividend date comes up prior to contract expiration.
Maximum profit
Covered call writers can capture both option premium plus share appreciation if out-of-the-money strikes are sold. Put-sellers capture option premium only.
Initial step
Covered call writers buy the underlying security in 100 share increments. Put-sellers place an appropriate amount of cash into the brokerage account which then “secures” that put.
Market outlook
Covered call writing works best in slightly bearish to bullish market conditions. Put-selling is best suited for slightly bearish to neutral market conditions.
Use in Self-directed IRA accounts
Covered call writing is universally allowed in IRAs while put-selling is allowed only by certain brokers.
Level of trading approval
Most brokerages require a higher level of trading approval for put-selling because they feel that it is not as intuitive as is covered call writing.
Early assignment
This is not an issue for covered call writing (assuming no tax issues) because we know our cost basis. For a declining stock, early assignment of a short put may result in a greater loss since notification may not come until the next trading day.
Cost to close when price declines
It will be much less expensive to close a short call than a short put. This is because call value declines with a decrease in share price while put premium increases with a decline in stock price. This will require us to set aside a greater cash reserve to buy back a short put on a declining security.
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Advantages of put-selling
In bear and volatile markets, put-selling can be used before buying a stock. Using out-of-the-money puts will allow us to buy a stock “at a discount” before writing an in-the-money call. This creates an additional layer of downside protection in challenging market conditions. In this same regard, put-selling can be used in lieu of setting limit orders when there is a desire to buy a stock but at a lower price than current market value.
Discussion
Covered call writing and selling cash-secured puts have the same profit and loss graph profiles but also differ in many ways. By understanding the similarities and differences between these two option-selling strategies, each investor can make the most appropriate decisions as to when and how to implement these strategies.
Market tone
Global stocks boasted solid gains this week, as major US indices set new records and European stocks enjoyed their best week since February. The S&P 500 Index gained about 4.05% for the month, setting a new all-time high. Oil prices dipped slightly this week, with West Texas Intermediate crude falling 58 cents a barrel to $51.10. This week’s reports and international news of importance:
- Global stocks continued to post strong gains this week as investors moved out of defensive asset classes, taking on more risk
- The strongest segments of the US market since the election have been materials, industrials, energy, financials and technology
- High-yield bond sector spreads remained compressed, with most sectors sitting at 52-week lows, indicating that investors are still seeking yield opportunities
- US investment-grade bond spreads narrowed as well, but slightly
- Yields on municipal bonds also fell this week, indicating a reversal of a recent selloff in the asset class
- The European Central Bank announced that it would extend its quantitative easing program until December 2017, although it reduced its monthly purchases
- The eurozone economy has improved in recent months, although two of this week’s data releases fell short of expectations. UK manufacturing output unexpectedly fell 0.9% in October, and German industrial production also disappointed
- Italian voters rejected a referendum on constitutional reform early last week, prompting Prime Minister Matteo Renzi to resign. The result continues the anti-establishment trend in the United States and Europe
- Austrian voters elected pro-European candidate Alexander Van der Bellen as president this week, opposing the anti-establishment trend in the European Union
- China’s trade data surprised analysts to the upside this week as imports and exports both increased sharply in November. Exports rose 0.1 % year over year, reversing a 7.3% decline recorded in October, while imports grew 6.7%, the fastest pace since 2014
THE WEEK AHEAD
- China’s industrial production and retail sales data are released on Monday, December 12th
- The Federal Open Market Committee meets on Tuesday and Wednesday, December 14th – 15th
- The eurozone’s industrial production figures are released on Wednesday, December 14th
- US business inventory, retail sales and industrial production data are released on Wednesday, December 14th
- US Consumer Price Index, NAHB housing market index and jobless claims data are released on Thursday, December 15th
For the week, the S&P 500 rose by 3.06% for a year-to-date return of +10.52%.
Summary
IBD: Market in confirmed uptrend
: 6/6- Buy signal since market close of November 10, 2016
BCI: I am currently fully invested and have an equal number of in-the-money and out-of-the-money strikes. Despite the bullish nature of the market since the election, I would still like to see the economic and global policies of the incoming administration more precisely defined. As a result, I have rejected a more bullish approach for the December contracts and probably for the January contracts as well.
WHAT THE BROAD MARKET INDICATORS (S&P 500 AND VIX) ARE TELLING US
The 6-month charts point to a bullish outlook. In the past six months, the S&P 500 was up 6% while the VIX also declined by 20%.
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