Cash Secured Puts vs. Covered Calls

Many investors use derivatives like options to make outsized profits during high volatility. But options can also be used to leverage bouts of lowvolatility and allow investors to pocket income while markets are flat. Two more popular options strategies are cash-secured puts and covered calls, where options are written and balanced with cash or stock to minimize risk.

While these strategies are similar in risk profile, a few differences could make one more advantageous than the other in specific markets. These options strategies are relatively easy to understand, but trading derivatives requires experience and expertise and isn’t recommended for novice investors.

What Are Cash-Secured Puts?

A cash-secured put is a trade where an investor writes a put option on a particular stock and then secures the position by having enough cash reserves in their account to cover the purchase of shares should the assignment occur. The amount of cash to secure the position is equal to 100 shares of stock at the option's strike price so that the investor can buy the stock should the option be exercised.

Here’s an example: Company CBA trades at $10 per share. If you expect the price to remain near that level, you could sell a put option with a $9 strike price and fund your account with cash to cover the position should the option be exercised ($900 minus whatever premium you obtained from selling the option). If the stock price stays at $10 through the life of the contract, the option will expire worthless, and you can pocket the premium. If the stock drops to $9, you would use your cash position to purchase the stock in case of assignment. The maximum profit for the trade is the premium from selling the option.

How Cash Secured Puts Work?

Cash-secured puts are a trading strategy for options. An investor sells put options and sets aside cash to buy the stock if needed. The investor chooses a stock that they think will perform well long-term but want to buy at a lower price. They write a put option with a specific strike price, agreeing to buy the stock at that price if the option is exercised. To secure this strategy, the investor reserves cash equal to the strike price times the number of shares. At expiration, there are two outcomes. If the stock price is above the strike price, the option expires worthless. The investor keeps the premium earned from writing the option. If the stock price is below the strike price, the investor may need to buy the stock at the agreed price. This strategy helps investors acquire stocks at lower prices while also generating income from premiums.

Why Should You Use Cash Secured Puts?

Cash secured puts are a way to invest that can help earn income and acquire stocks. This strategy involves selling put options on stocks you want to own. You need to have cash ready to buy the shares if the options are exercised. By selling these options, investors can earn premium income. This approach also allows them to buy quality stocks at good prices. Cash secured puts can reduce risks and take advantage of market changes. Understanding this strategy can help investors make smarter decisions for financial growth.

Income Generation

Selling cash-secured puts gives investors the chance to earn premium income. When you sell a put option, you receive a premium right away, which can improve your overall returns on capital while you wait for a possible buying opportunity.

Buying Opportunities at a Discount

Cash-secured puts allow you to buy a stock at a lower price if you're interested. If the stock drops below the strike price by the expiration date, you might have to purchase the shares, which means you could obtain them for less than the market price.

Lower Risk Profile

Cash-secured puts tend to be less risky than naked puts because the funds to buy the underlying stock are reserved. This helps minimize the risk of margin calls and provides a clear exit strategy, ensuring you have the means to purchase the shares if assigned.

Considerations Before Using Cash Secured Puts

Before exploring cash secured puts, it's important to know some key factors. Cash secured puts are an advanced options trading strategy. They involve selling puts while keeping enough cash to buy the underlying stock if assigned. This strategy can generate income, but it also has risks. Investors must consider their risk tolerance, market conditions, and the financial health of the asset. It's important to understand assignment, market volatility, and potential returns. By reviewing these factors, you can effectively manage cash secured puts and align them with your investment goals.

Market Conditions

It's important to assess the market as a whole along with individual stock trends. In a bearish market, there's a greater chance that a stock might fall below the strike price, which could result in assignment. Gaining insight into market volatility and sentiment can aid in making more informed decisions.

Liquidity and Spreads

It's important to assess the liquidity of the options you're looking at. Less liquid options can have wider bid-ask spreads, which might reduce your profits. Choose stocks that have higher trading volumes and narrower spreads for better pricing and execution.

Cash Availability

Make sure you have enough cash available to buy the underlying stock if you're assigned. With cash-secured puts, you need to reserve the funds necessary to purchase the shares at the strike price, which might restrict how you can use that cash for other investments. It's important to consider your overall cash management strategy.

What Are Covered Calls?

A covered call is a strategy similar to a cash-secured put in terms of risk and profit ranges, but you own the underlying stock. It’s two trades — 100 shares of stock are purchased and then a call option with a strike price at the purchase price of the stock. If the stock declines, the option will expire worthless, and you keep the premium. If the stock increases, you can match your assignment risk with the shares you own. Max profit is the premium from the option, and while downside risk is minimized, you won’t benefit from any potential stock price appreciation.

If Company CBA trades at $10, you can execute a covered call by buying 100 shares and selling a call option with a $10 strike price. If the stock stays at $10 or declines, the option will expire worthless, and you can keep the premium. Losses on the overall position will be lower than just owning the stock outright. If the stock goes to $12 and the option is exercised, you can cover your assignment with the 100 shares in your account.

How Covered Calls Work?

Covered calls are an options strategy. You need to own at least 100 shares of a stock. At the same time, you sell an out-of-the-money call option. This means choosing a strike price above the current market price. Selling this option gives you a premium, which generates extra income. If the stock price stays below the strike price at expiration, the option expires worthless. You keep the premium, so your profit includes the premium and any increase in share value. If the stock price goes above the strike price, the option is assigned. You must sell your shares at the strike price. You still keep the premium, but you might lose out on selling at a higher market price. This strategy can boost returns, but it has trade-offs. Be careful, as it may limit profit from rising share prices.

Why Should You Use Covered Calls?

Covered calls are a popular trading strategy. They can boost the income of your investment portfolio while managing risk. By selling call options on stocks you own, you can earn additional income through premiums. This increases your overall returns. This strategy works well when the market is flat or mildly bullish. It lets you use your existing stock holdings without losing ownership. Covered calls also provide some downside protection if the stock price drops. This strategy helps optimize your holdings and allows for safer engagement with the options market. In the next sections, we will discuss the main advantages of covered calls, potential risks, and tips for using this strategy effectively to reach your financial goals.

Income Generation

Covered calls allow you to earn extra income from your stocks. By selling call options on shares that you already own, you receive premiums that can increase your overall return, particularly in stable or mildly positive market conditions.

Downside Protection

The premium gained from selling the call option provides some protection against possible decreases in the stock's price. Although it doesn't completely remove the risk of loss, it can help reduce some of the decline, effectively decreasing your breakeven point on the stock.

Defined Exit Strategy

Covered calls can help you plan an exit strategy. If the stock price goes above the strike price, your shares might be called away, letting you sell at a set price. This can be useful if you have a specific exit point in mind, as it allows for potential profit and a structured way to manage your stocks.

Considerations Before Using Covered Calls

Before using covered calls, it's important to understand some key factors. Covered calls involve owning an asset and selling call options on it. This can create extra income. However, it also has risks and limits that investors must consider. Your financial goals, market conditions, and the asset's characteristics are important in deciding if this strategy is right for you. You should also think about how volatility, potential gains, and obligations from sold options can affect your decisions. By considering these factors, investors can use covered calls effectively in their financial plans.

Stock Price Movement

Selling covered calls can restrict your potential for profit. If the stock price increases significantly above the strike price, you might miss out on substantial earnings as your shares could be called away. It's important to think about your expectations for the stock and whether you are okay with limiting your potential gains.

Expiration and Strike Price Selection

When selling call options, it's important to pick the right expiration date and strike price. If the strike price is too close to the current stock price, the chance of being assigned increases, but if it's too far, the premiums may be lower. Finding a balance between risk and reward is essential.

Tax Implications

It's important to consider the tax implications of covered calls. If your shares are called away, you might face capital gains taxes based on your holding period. Being aware of your tax circumstances and seeking advice from a tax professional can aid in making informed choices.

Cash Secured Puts vs. Covered Call: Similarities

Cash-secured puts and covered calls are different types of protective trades, but they also have many similarities. Here’s how both options strategies can be beneficial to your portfolio:

Require Investors to be Skilled

While these are two more straightforward market-neutral options trades, using derivatives requires a particular proficiency as an investor, especially when selling options instead of buying them. Always understand the construction of the trade before risking any capital with options.

Additional Income to Your Portfolio

Cash-secured puts and covered calls may sound like they have different goals, but the ideal outcome is the same: extra income during flat markets. In both trades, the primary profit source is the option premium received, and the upside is limited compared to direct ownership of the underlying stock.

Profit and Loss Graphs

Both trades have similar risk profiles, which is evident when looking at the graph of potential outcomes. Breakeven points are similar, upside is limited, and max profit is the option premium. Risk is minimized but so are potential returns.

ETF or Stock Selection Process

Selecting securities for these trades involves a similar process. Because the benefits of stock price appreciation are limited, the ideal securities are low-volatility stocks and exchange-traded funds (ETFs) with liquid options markets. One particular selection technique is the Wheel Strategy, which combines cash-secured puts and covered calls for a consistent income stream.

Conservative Option Strategies

In terms of risk and profit, these are two reasonably conservative strategies for options trades. The downside is limited because the stock is owned or cash-secured, and gains are limited. Both techniques are ideal for markets with low volatility.

Cash Secured Puts vs. Covered Calls: Key Differences

The key to successfully using cash-secured puts and covered calls is understanding the slight differences between the two trades and knowing when to use each. Here are the key factors that distinguish the two strategies:

Primary Motives

An investor using a cash-secured put has a neutral slant but also looks for an opportunity to purchase shares at a lower market price. A covered call is better for an investor who already owns the underlying stock.

Market Outlook

While both trades can benefit a neutral market, cash-secured put sellers have a more bearish slant than covered-call sellers. But covered call sellers can make money in slightly rising markets if the call option strike price is above their purchase price, so the mindset is more bullish.

Possible Profits

Cash-secured put sellers can only make a profit from the option premium. However, covered-call sellers can profit from option premiums and stock dividends and appreciation if the call's strike price is above the purchase price of the stock.

Dividends

A covered call strategy will allow you to collect dividends because you own the underlying stock. While a cash-secured put requires a similar level of capital, you don’t own the stock, so no dividends are paid. 

Self-Directed IRAs

If investing in a self-directed individual retirement account (IRA), you must check with your broker to see whether cash-secured put writing is allowed. Covered call writing is Financial Industry Regulatory Authority (FINRA)-regulated and usable in all self-directed IRAs.

Both Strategies Have Similar Risk Profiles But Also Subtle Differences

The differences may be subtle, but they should be well-understood to maximize the benefits of both strategies. For example, a covered call is likely the superior trade if you already own the stock because you don’t need to make two transactions to open the trade. If you don’t own the stock and think you can get shares cheaper in the future, a cash-secured put might be better because transaction costs are lower. Consider your own risk tolerance and investment goals when deciding between the two strategies.

Frequently Asked Questions