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Covered call alternatives: Cash-covered put options and spreads

There are two established covered call writing alternatives for conservative investors: cash-covered put options writing and spreads.

Cash-covered put writing

When you write a put and keep enough cash in your account to cover the most you could lose, then you have created what is known as a “cash-covered” put. You get your maximum gain if the stock ends up above the strike price of the put and you get to keep the entire premium. On the downside, you are protected by the put premium.

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Cash-covered puts and covered calls are what are known as equivalent positions. are what are known as “equivalent positions” to covered calls. That is a cash-covered put and a covered call on the same stock, with the same strike and expiration will offer up nearly identical gains and losses for different outcomes of the underlying stock.

We compare the outcomes of (1) a covered call – buying 100 shares of Iron Mountain (IRM) common at $35.38 and writing one October 2011 $35 call at $2.00 (total cost $33.38 per share or $3,338 on one covered call) and (2) a cash-covered put – writing one October 2011 $35 put at $1.80. If the put is fully covered by the difference between the strike price amount and the premium (in this case $33.58 per share or $$3,358 on one put), the outcomes of the two strategies are very close.

With the covered call, if the stock ends up above $35, gains and losses on the tangible value of short call and the stock will offset each other and the investor will keep the original time premium plus any dividend (provided the call is not exercised before expiration). With the cash-covered put write, as long as the stock ends up above the $35 strike price, investors get to keep the entire put premium of $1.80 or $180 on the transaction.

Also with the put, investors collect interest on the cash used to cover the position. In our example, this works out to be $5 for the 120 days from the 7/8/2011 trade date to the 10/22/2011 expiration.

Which strategy is best?

In this particular example, the covered call offers a slightly better return than does the cash-covered put, with a gain of $192 versus $185 if the stock ends up above the strike. However, this is not always the case. Sometimes, the comparable cash covered put offers a better return. Moreover, the actual dollar returns should not be your only consideration. For instance, if the stock ends up above $35 at expiration, the owner of the covered call is forced to buy his or her short call (thus, losing on the bid/ask spread and the commission) or allowing, their shares will get “called away,” (i.e., delivering the shares at the strike price, which also involves a commission). By way of contrast, the writer of the cash-covered put has no close-out transaction.

In addition, with the covered call, you have to worry about the possibility that the in-the-money call will be exercised before expiration. Usually, this only happens when the stock has what is known as an ex-dividend date shortly before expiration. The ex-dividend date is the day on which the company identifies the owner of the stock. Thus, the holder of a long call that is in-the-money might want to exercise the call (i.e. buy the stock) before expiration so as to collect the dividend.
Simple rules of thumb are:

  • If the stock is above the strike price, it makes more sense to write the cash-covered put.
  • If the stock is below the strike price, then the covered call makes more sense.

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Comparing rates of return

In the following, we compare how you calculate the annualized return, the breakeven percentage, and the maximum profit on a covered call and a cash-covered put. Notice that the cash-covered put can require a larger outlay of funds, but this difference is made up by the interest earned on these funds. Notice also that with the covered call, we often need to add dividends to the return, breakeven, and maximum profit calculations, while with the cash-covered put, we have to add the interest income to these same calculations.

Covered call alternatives: Using spreads

Another viable covered call alternative, and a very capital efficient one, is the use of option spreads. Let us start with the simplest example, comparing a bull call spread with a covered call. In Figure 17 below, we show an example. Here we have bought the September $20.00 call for $5.30 as a substitute for the stock. The total cost for establishing this spread is $295 ($530 for the long call minus $235 for the short call). This cost, of course, is considerably less than the $2,222 required for the covered call ($2,457 buy the 100 shares of DISH minus $235 for the $24 call).

Notice that in our example the maximum profit on the bull call spread is $105 versus $178 for the covered call. This is because the $20.00 call has $73 worth of time premium. However, you have to remember that with the bull call spread, you have some insurance. If the stock drops by 25% to $18.43, you only lose $295 with the bull call spread, while with the covered call, you lose $379. Also, with the spread, the return on capital is a lot higher. If the stock ends up above $24 at expiration, you get a 35.6% return on your investment net of commissions ($105 maximum profit divided by $295 cost of capital). With the covered call, your return is only 8.0% ($178 divided by $2,222), which less than one-third of the return on the spread.

A bull put spread

You can also use a bull put spread as a covered call substitute. In Figure 18 on page 17, we show an example of a credit put spread as a covered call alternative. Here, we wrote the September $24 put on DISH for $1.80 and bought the $20.00 put for $0.75 as a hedge on this short put. This spread is established at a credit of $105 ($180 – $75); however, the exchanges require you to post a margin that is equal to the maximum amount you can lose. This margin works out to be $295 – i.e., the difference between the two strike prices times the number of underlying shares ($24 – $20 times 100 or $400) minus the $105 premium you have taken in. One nice feature of the bull put spread is that if the stock ends up above the strike price of the short put, you don’t need to close out any positions.

The long diagonal spread

Rather than buy a lower-strike call with the same expiration as the one you have written, you can buy a longer-dated call (also with a lower strike) as a substitute for the stock. We call this combination a long diagonal spread. In the Graph in Figure 19 below, we show an example in which we have bought the in-the-money January 2012 expiration $17.50 call for $8.00 as a substitute for DISH and written the $25 September call for $1.80. One nice feature of this type of position is that, at the September expiration, you can roll your short call just as you would with a regular covered call and continue to use your long call as a substitute for the stock.

 


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