In last week’s article, which you can read here,
I wrote about buying long-term put options as a part of a long-term investment strategy. These can be used to protect a long stock position; or as a part of various other strategies. The attraction of buying the long-term puts was that they were cheap. Today we’ll discuss another way to use puts as part of a long-term investing strategy.
I mentioned that a favorite option strategy for long-term investors is covered calls. In this strategy, you own an asset, either a stock or exchange-traded fund. You then sell short-term call options on this asset. These calls put money in your pocket immediately, in exchange for your obligation to sell the asset at the calls’ strike price, if called upon to do so. If the underlying asset’s price does not exceed the call strike price when the calls expire, the calls will not be exercised (except in rare and easily-foreseen cases). So if you select a call strike that is higher than the highest price you expect the stock to reach by expiration, and you are right, the call premium you collect is gravy on top of whatever return you otherwise get by owning the stock. So you get to keep any price change in the stock, as well as any dividends that it pays, along with the call premium.
The downsides are two: first, you give up any upside potential on the stock above the strike price. Since you are obligated to sell it at that price, it does you no good if the stock exceeds it. If that does happen, you will lose the stock – it will be “called away” from you, and you will be paid an amount equal to the strike price.
Secondly, with the covered call strategy, you are still exposed to downside moves in the stock’s price. Since you own the stock, you lose money if its price goes down. You do lose less, however than someone who owned the stock and did not sell any calls; your loss is less by the amount you were paid for the calls.
So the covered call strategy increases your return on the underlying asset, by whatever amount you receive for the calls, unless the stock ends up at expiration above the call strike. In that case, your return may be less than it would have been had you simply owned the asset and not sold the calls.
Notice I said that “your return may be less.” It will be less only if the underlying price at expiration is above the strike price, by at least the amount of the call premium. If not, then the covered call still pays better.
Below is an example of a covered call position, where we sold a $100-strike call on a stock that was at $98:
Note the bold cells in the table above. In the columns labeled “Stock Alone” and “Stock (Cov Call),” these bold numbers highlight the fact that we don’t get all of the profit on the stock if its price exceeds the call strike at expiration. We only get that portion from our cost ($98) up to the call strike ($100). In this case our profit on the stock itself tops out at $2.00 per share, no matter how much higher the stock’s price goes.
Also note the bold items in the rows where Stock Price at Expiration = $97.00 and $98.00. At $97.00, the covered call position would break even (Profit/Loss = $0), while the Stock Alone column at the $97.00 price shows a $1.00 loss. With the stock alone, we need an underlying price of $98 to break even. This demonstrates that the breakeven price for our position is reduced by selling the call. It is, in fact, reduced by exactly the amount we received for the call, which makes sense.
Finally, note the last column – “Covered Call Advantage.” This represents how much better or worse off we would be by selling the call, vs simply owning the stock alone. It highlights the point that at any expiration price of the underlying asset at or below the call strike price ($100), we are better by selling the call; and that advantage equals exactly the amount we received for it ($1.00 in this case). If the underlying price at expiration is higher than the $100 call strike, then the covered call still has an advantage (note the row where Stock Price at Expiration = $100.50), up to the point where the price of the underlying at expiration is more than the call strike price plus the call premium (in this case $100 + $1 = $101). At that price ($101) the return with and without the short call is the same. At any higher underlying price than $101), the covered call position earns less than the stock by itself.
OK, so covered calls can be good for increasing the return on your long-term positions. What if you do not have a long stock position? This might happen, for example, if you had been selling covered calls, and the stock got called away from you.
In that case, you could simulate the covered call position, simply by selling a put option at the same strike that you would have been selling the call option if you had the stock. You would be obligating yourself to buy the stock at $100, so you would need that amount in your account to be earmarked for this purpose. You get credit against this $100 requirement for the $3 you receive for selling the put. So your net cash requirement is $100 – $3 = $97. This is the same as the cash that would be required to do the covered call ($98 to buy the stock less $1 received for the call).
Since the $100 put strike is higher than the current underlying price at $98, this put option will be in the money, so its premium will be higher than the call at the same strike; however, its time value will usually be very close to the same as that of the call. This is because the degree of uncertainty of the stock going from its current $98 to $100 is the same, whether we’re talking about puts or calls; and time value is a measure of uncertainty. The amount of time value in the put and the call at the same strike is not always exactly the same, but that is a topic for next week.
Below is another table of the same stock and covered call results, with three additional columns added. These show the profit or loss at expiration of a short put position, where we sell a $100 strike put at $3.00. At the $100 strike, the put is currently in the money by $2.00 ($100 strike – $98 current price). It has time value of $1.00, for a total current put price of $3.00. This is compared to the $100 call, whose value was $1.00. Since the call was out of the money, that entire $1.00 represented time value. So, as is commonly the case, the $100 put and the $100 call have the same amount of time value, which here is $1.00.
Here’s the table showing the short put results:
Notice that the profit or loss on these two positions is exactly the same at any underlying price at expiration. The values in the columns Cov Call Total and Short Put Total are the same in every case. These two positions are equivalent. So if we wanted to do a covered call without the call (and without the stock!) we could accomplish exactly the same thing, with exactly the same amount of risk and payoff, by selling a naked put.
Next week we’ll finish off this example, and talk about what happens in the unusual case, where the time value in puts vs calls at the same strike is in fact not close to the same.
Meanwhile, for comments and questions on this article, contact me at firstname.lastname@example.org.