Covered calls and short put have the same risk and reward at the onset. However, when the underlying stock price declines and these strategies start losing money, essential differences begin to emerge in the ability of the investor to manage the risk. Even though the risk is the same in both strategies, the covered call offers several significant advantages over short puts (naked puts) for investors looking to repair or adjust their losing position.
Covered Calls are one of the most popular strategies for investors. This strategy involves buying a stock and then selling or writing or shorting a call option. Selling the call option means you are promising to sell your stock at the strike of the call option and you receive cash upfront to make this promise. For example, you can buy a stock selling for $100 per share and then short a call at $100 strike in return for $3 per share. The cost basis of this position is $100 – $3 = $97 per share which is also the maximum risk. The maximum reward is $3 per share if the shares are sold for $100 per share.
Covered Call $100 stock + Short Call $100 strike for $3 cash
Maximum Risk = $97 per share
Maximum Reward = $3 per share
Short puts or naked puts are the same risk and reward as a covered call. Shorting or writing a put means you are promising to buy the stock at the strike of the put. For example, you may short a put at the $100 strike in return for $3 per share of cash. The maximum reward is the $3 per share collected at the start of the trade. The maximum risk is that the short put may be assigned and you have to buy the stock for $100 per share. However, you get to keep the $3 per share of cash collected upfront, so the actual cost basis of the stock is $100 – $3 = $97 per share.
Short Put $100 strike for $3 cash
Maximum Risk = $97 per share
Maximum Reward = $3 per share
At the start of the trade, both positions look identical. The short put may even look more attractive due to the commission impact. You will pay lower commissions with a naked put as only one security is being transacted versus two for the covered call. The short put may just expire worthless if the stock is above $100 at expiration saving you another round of commissions at the end of the trade. Closing out the covered call, however, will require commissions once again.
If the stock price declines, the covered call offers several important advantages for investors looking to manage their position rather than just take a loss. The process of repairing or adjusting a losing position is at the heart of the Options Animal methodology. Let’s compare the two strategies if the stock declines from $100 today to a lower price in the future.
One of the most important advantages of the covered call is that the short call may be bought to close for a profit and another short call may be opened for more cash. This requires no additional cash, lowers the risk of the position and maintains some profit potential. For example, while the stock is falling the original short call may be bought to close for less than $3, say $1 per share. Now another short call may be initiated for another month out, say at the $97.50 strike for $3 per share in cash. The cost basis is now reduced from $97 (Original Cost basis) + $1 (to buy back original short call) – $3 (from the new short call) = $95 per share. The new profit potential if the stock is sold for $97.50 is $2.50 per share. This is a repair or adjustment strategy known as rolling of the short call down in strike and out in time. If the stock continues to decline, this process can be repeated to lower the cost basis again and maintain some profit potential if the stock recovers. With another roll of the short call down and out, the cost basis may be reduced to $93 or even lower.
New Position Risk = $95 per share
New Position Reward = $2.50 per share
This process of initiating new short calls is not readily available with a short put. A short call is a promise to sell stock and if you don’t own the stock (as in a short put); you are promising to sell something you do not possess. This short call now represents theoretically unlimited risk if the stock were to go higher. For example, say you initiated short calls for $100 per share strike in return for $3 per share when the stock was falling. The news came out that your stock is being acquired by another company for $120 per share and your stock goes to near $120 overnight. You will keep the $3 per share from the short put and the $3 per share from the short calls, but the short calls will now be losing $20 per share for an overall loss of $14 per share. With a covered call, you will walk away with the $2.50 per share profit.
You may also benefit from collecting a regular or special dividend on the stock in a covered call. If our $100 stock pays a quarterly dividend of $0.75 per share, we can collect $3 per share in a year just from dividends further reducing the real cost basis of the covered call. This benefit is not available to short put writers.
Finally, a stock is forever while short puts have a limited life to expiration. Knowing that you have time on your side to make adjustments means there is relative ease and less mental anguish in a covered call compared to a short put. Rolling the short call or initiating other adjustments like adding long puts to create a collar trade are relatively easy for sophisticated option traders.
Even though a covered call and a short put have the same risk, the ability to manage this risk is much better in a covered call than a short put. For investors looking to repair their losing strategies rather than just take a loss at the first sign of trouble, the covered call is the better strategy.