Why Should Investors Consider Covered Calls and Cash Secured Puts?
At first, options selling strategies can be daunting: the options seller has the obligation to buy/sell the underlying security at the strike price, no matter how low/high the price is. It sounds risky!
But different strategies carry different levels of risk, and these two strategies are commonly used to generate income with a relatively higher probability of success. Why? Let's find out!
Quick View of Selling Options
An option is a contract. If you buy an option, you own the right to buy/sell shares at a predetermined price on or before a specific date. Conversely, an options seller is obligated to sell/buy shares if the buyer exercises his right after receiving the premium.
The upside potential is limited to the premium received by the seller, and the potential loss is substantial.
- A call seller is obliged to sell the underlying security at the strike price before the expiration date if assigned.
- A put seller is obliged to buy the underlying security at the strike price before the expiration date if assigned.
Why Use Covered Calls
A covered call strategy is created by buying (or holding) stock/ETF shares and selling call options using those shares. It is often used to collect cash income when the price forecast for a stock is neutral-to-bullish.
Suppose you intend to hold 100 ABC in your portfolio long-term. After doing some research, you conclude that the ABC stock should experience short-term sideways movement. In that case, a covered call strategy might be a choice to generate income by selling calls. You will receive the premiums from selling call options as additional income, enhancing your portfolio returns. Of course, you still risk having to sell your ABC shares for less than market price if the call is assigned.
As an option seller, your hope is that the call option expires worthless. That way you can pocket the premiums without having to sell the stock. But stock prices don’t always go the way you expect. What if the stock price starts rising, and nears the strike price of your covered call? If you don't want to sell your stocks, there are two other choices for you before expiration.
- Exit the covered call position: you can buy back the call option in the market to close the covered call position.
- Rolling the covered call position: you can roll up or down your short calls by closing an existing covered call and selling another covered call on the same stock.
How Cash-Secured Puts Improve Returns
A cash secured put strategy is created by selling a put at a specific strike price while simultaneously posting cash as collateral in the event the put option is exercised and shares are obligated to be purchased.
Suppose that James, after doing some technical analysis, believes that ABC stock will not drop below $380. If James has no intention to buy or hold ABC shares, selling a cash-secured put is a way to enhance returns on idle cash in his account. Let's take a closer look!
The return calculation shows the ideal outcome for the cash-secured put seller, which happens when the strike price is below the stock price at expiration. However, as a put seller, James has to buy the 100 ABC shares at $380 with his collateral cash if the put option is assigned. If the stock price drops by an amount greater than the premium received, he will start losing money. If James is unwilling to hold ABC shares, he can either buy back the put option to close the cash-secured put position or roll down/out his position.
Next Step: Explore More!
Here we mainly talk about how to use the two strategies to generate income, which is relatively easy to understand and popular among investors. As you become more familiar with them, you will find they can be helpful tools when building your portfolio.
Want to practice selling covered calls and cash secured puts?
