Options Building Blocks: Why Should Investors Consider Covered Calls and Cash-Secured Puts?

Nothing is certain in the financial markets. If we’ve learned anything in 2020, it’s that earnings, interest rate decisions, political events, pandemics, and other events can all lead to market volatility. And when markets are volatile, investors might be concerned about large swings in their portfolios. Fortunately, there are options strategies that can help reduce a portfolio’s volatility—and do more.

If you don’t have much experience trading options, two strategies that could help generate additional income, achieve a higher probability of success, and reduce volatility of returns are:

• Selling covered calls
• Selling cash-secured puts

In many ways, these two strategies are similar in terms of their risk/reward profile. Both limit potential upside in exchange for a higher probability of success by lowering break-even price points. But there are also some key distinctions.

Let’s start by differentiating the two strategies.

What Is a Covered Call?

A covered call strategy means writing a call option against an equivalent amount of long stock. At that point, you own stock as well as options on the stock. And although you’re holding two separate positions simultaneously, it’s considered a single position within a portfolio.  

You can enter a covered call position in one of two ways:

• Simultaneously buy 100 shares of stock and sell one call option
• Sell one call option against 100 shares of stock that you already hold

In both cases, the net cost of the covered call position is the amount you paid to buy the stock minus the premium received from selling the call option. For example, suppose you buy 100 shares of XYZ at $100 and sell one call option with a strike price of $100. You receive $5 in premium. In this covered call example, you’d spend $10,000 on the stock and collect $500 in options premium for a net cost of $9,500.

Cash-Secured Put: How Secure Are They?

A cash-secured put is a put option written within a portfolio with cash set aside to cover the potential obligation. That’s because when you sell a cash-secured put, you’ll be obligated to buy 100 shares of stock if the option is exercised by the put holder.

The cost to enter a cash-secured put is equal to the strike price of the put option multiplied by 100, minus the premium received. Suppose you sell a put option in XYZ with a strike price of $100 and receive $5 in premium. In this case, you’d have to set aside $9,500—the $10,000 required to buy the stock minus the $500 in options premium received.

In these examples, both strategies have similar risk profiles:

• At expiration, the break-even price is $95 per share ($100 minus $5 premium received).
• At expiration, above $100 profitability is limited to $500.
• At expiration, below $95 the risk would be penny-for-penny with the stock price.

Remember, since short options can be assigned at any time up to expiration regardless of the in-the-money amount, the options writer needs to be comfortable with either selling their position at the strike price or buying the stock at the strike price at any time up to expiration. 

Why Might Investors Use These Strategies?

Investors can use the covered call and cash-secured put strategies to:

1. Generate additional income in a portfolio. Because options contracts are a decaying asset, you can make use of this time decay to create additional income around your core positions. Because both strategies involve collecting premium by selling options contracts, you can look to generate additional income even if the stock price remains stable. If the options contracts in the above examples expired in 30 days, each could lead to an additional 5% in income.

2. Improve the probability of success by lowering break-even price points. Covered calls and cash-secured puts could help you lower the break-even price points on your investments in exchange for limited upside. Going back to the examples above, both strategies would have a break-even price point of $95. If you simply bought 100 shares of XYZ at $100, the break-even price point would be $100. That extra $5 cushion increases the likelihood that you might profit on the investment and reduces your overall risk.

3. Decrease the volatility of portfolio returns. Many investors are uncomfortable with significant swings in their portfolios. These two strategies can help reduce the magnitude of such swings.

How’s that last one work? Great question. Let’s compare the returns on either of our examples at expiration versus buying 100 shares outright:

 So by selling covered calls and cash-secured puts, you could reduce the overall swings in your portfolio.

Strategy Selection for Investors

Although both strategies have the same risk profile, there are some situations where one could be preferred over the other.

• A covered call is typically preferred if you already have 100 shares of stock, and you’re willing to sell those shares if they’re called away.
• A cash-secured put is typically preferred if you’re looking to accumulate shares at a lower price.

The bottom line? The covered call and the cash-secured put are both useful strategies for investors to explore as they build their portfolios.