When reaching retirement, many investors shift their focus for their savings to generating a reliable and steady income, effectively replacing the paycheck from their job that they no longer earn. There are a number of different investment strategies to use to generate income, with one of the most popular being the selling of equity options.
Many investors who sell equity options tend to focus on selling the two most basic types, which are covered calls and cash secured puts. Investors often ask us which of the two types of options are the best for them to pursue in selling in order to generate income. Let’s take a few moments to discuss the similarities and differences between covered calls and cash secured puts and why investors might be drawn to one or the other.
Equity options are a contract between two parties concerning the sale of shares of stock at a predetermined price (the strike price). Covered calls are contracts where the seller of the option agrees to sell a block of shares which the own at the strike price to the buyer of the call if the buyer chooses to exercise the option prior to a predetermined date (the expiration date). To get the rights to buy the shares at the strike price, the buyer of the option pays the seller a premium in cash.
Cash secured puts are very similar, except that the roles are effectively reversed. The buyer of the put has the right to sell shares to the seller of the contract at the strike price; however, the seller of the cash secured put still receives a premium from the buyer.
Ultimately, there are a number of different factors that will determine whether or not it would be preferable for a particular investor to sell covered calls or cash secured puts. These factors will include characteristics of the individual investor as well as market factors that are present at the time of trading. Below, we’ll discuss how each of these factors can influence the decision to sell a particular type of option.
The amount of income that a person seeks to make off an option trade can play a large part in determining which type of option to trade. As stated earlier, a seller of either a covered call or cash secured put will receive a premium payment for the option contract from the buyer. However, selling a covered call that is out of the money (i.e. at a strike price that is higher than the market price) creates an opportunity for further capital gains if the stock price appreciates. But, the tradeoff is less income at the time of selling the covered call. The option buyer will only exercise the option at the higher strike price if the market price appreciates above the strike, creating an in the money option.
It is also possible that the option seller owns the underlying shares of stock because the stock is a dividend payer; the option seller may seek to continue to earn the dividend on the stock for the foreseeable future. It is also possible the investor believes the stock’s price could appreciate significantly. In this instance, the investor won’t want to sell the stock or cap their upside potential. Selling a cash secured put may be more advantageous to the investor than utilizing a covered call. The investor will still receive a premium for selling the option, and will have no risk of having the shares sold if the buyer exercises the option. Furthermore, the seller may have the opportunity to acquire more shares of the same position, which may be appealing to them.
The risk tolerance of an individual investor, and the potential opportunity costs that they are willing to absorb, also play a role in determining the type of options they will sell. Selling a covered call option limits the gain that an investor can earn; the profit on the trade is capped at the premium the seller receives plus any profit from the sale of the underlying stock (assuming that the call was sold out of the money). If the underlying stock sees a large increase in its market price, the seller may find that they would have made more money by not selling the call option at all and simply waiting for the appreciation.
In this scenario, the seller may have been better off selling an out of the money cash secured put; the put would have earned a premium and would presumably have been allowed to expire by the buyer. The seller would therefore be left with shares that have greatly appreciated in price, which he or she is now free to sell at their discretion.
Related to risk tolerance and opportunity costs, the forces at play in the market as a whole also factor into deciding which type of option to purchase. Covered calls are generally interpreted as bullish in nature; most of the investors who sell them expect the market, and prices in it, to rise going forward. Conversely, cash secured puts are generally viewed as being bearish, and are frequently sold by investors who are expecting the market to decline.
At optionDash, we make it our goal to help you to search for the best covered call stocks and cash secured puts, allowing you to maximize the income that you wish to earn on your investment account. Our free-to-use covered call screener helps you to find the best covered call options available, with additional screening criteria (including our proprietary Stock Scoring System) available for a low price subscription. The subscription also grants you access to our cash secured put screener, for those inclined to trade puts instead of calls.
Robert Brauer, CFP works as a financial advisor and writer at optionDash. He is passionate about spreading his knowledge about stocks and option trading for new and experienced investors. optionDash helps investors find income-producing covered call and cash-secured put trades.