Combining cash-secured puts with covered call writing is a viable strategy, especially in bear market environments or if the investor has a low risk-tolerance, notes Alan Ellman of TheBlueCollarInvestor.com.
Covered call writing can be used in conjunction with other strategies such as portfolio overwriting and dividend capture strategies. I have highlighted many of these covered call-related strategies in my books and DVDs. One of the strategies that has captured the interest of many of our members is the use of cash-secured puts. The cash-secured put involves writing (selling) a put option and simultaneously setting aside enough cash to buy the stock.
The strategy can be used in one of three ways:
- Generate income from premiums (you do not want exercise)
- Purchase a stock for your portfolio “at a discount” (you would like exercise)
- To be used to enter a covered call position (either exercise or non-exercise will work well)
In today’s article I will focus in on a strategy that incorporates both cash-secured puts and covered call writing.
Overview of the Strategy
We are bearish on the overall market or have a very low risk-tolerance and do not want to pay full price for the shares before writing our call options. Selling a put option at a lower price than current market value (this is out-of-the-money for puts) gives the put buyer (holder) the right to sell us the shares at this lower strike price. The option will be exercised if the price falls below the strike. If this occurs, we can then sell a call option on this “discounted” stock.
Diagram of the Strategy
Click to Enlarge
Real life example of entering a covered call position “at a discount.”
Here is a put options chain for New Oriental Education & Technology Group (EDU), a stock on our premium watch list as of 8-16-13:
Click to Enlarge
The Trade
- With EDU trading @ $22.50 we would like to buy it at $22
- Sell 1 x September (one-month out) $22 put, giving the option holder the right to sell you the stock @ $22
- Deposit $2200/contract into your brokerage account making the trade “cash-secured” or “covered”
- The initial return is $60/$2200 = 2.7%, 1-month return (must be monitored if price drops dramatically)
- If stock price drops below $22 by expiration we will buy shares @ $22
- Write covered call on newly acquired shares
Advantages
- Shares are acquired at a cost basis of $21.40 ($22 – $0.60), not $22.50
- If unexercised, we still generate a 2.7%, one-month return
Disadvantages
- Maximum profit is put premium, no share appreciation
- Monitoring essential if share price declines dramatically (same for covered call writing)
- Must master the differences between calls and puts (in-the-money and out-of-the-money are inversely related for calls and puts)
Conclusion
Combining cash-secured puts with covered call writing is a viable strategy especially in bear market environments or if the investor has a low risk-tolerance. Before considering using this strategy an investor must master and understand the differences between call and put options. The same stocks that are great covered call writing candidates on our premium watch list are also great candidates for selling cash-secured puts.
By Alan Ellman of TheBlueCollarInvestor.com
