Cash Secured Puts vs. Covered Calls
When diving into options trading, two strategies that consistently rise to the forefront are cash secured puts and covered calls. While both aim to generate income from stocks, each comes with its own set of advantages and nuances. Which one should you choose? Let’s explore both strategies in detail to help you make an informed decision.
In the world of options, traders often face a dilemma when deciding between cash secured puts and covered calls. Both strategies are widely regarded as bullish, designed to profit when a stock remains steady or rises in value. However, their differences lie in how and when they can generate returns and the risks involved. Understanding these distinctions can help you maximize profits and minimize risk in your portfolio.
Covered Calls: Simplicity and Steady Gains
A covered call strategy involves holding a stock and selling call options against that stock. The primary goal is to generate consistent income from the premium collected by selling calls.
Why Are Covered Calls Popular?
- Human Optimism: Investors typically prefer stocks to rise in value, and covered calls align well with this optimistic view. The stockholder benefits if the stock moves up slowly or stays flat, allowing them to keep the premium.
- Steady Income: This strategy offers a way to generate income, especially in sideways markets. The premium received acts as a buffer, providing downside protection.
- Easy to Understand: For many, covered calls are straightforward. You’re selling the right for someone to buy your stock at a higher price (strike price) and pocketing the income if the stock doesn't soar too high.
However, the downside to covered calls is if the stock skyrockets, the investor’s profits are capped at the strike price of the call, potentially leaving money on the table.
Cash Secured Puts: Gaining by Waiting
A cash secured put involves selling a put option with the obligation to purchase the stock if it falls below a predetermined price. For this, the seller collects a premium, but they must have enough cash on hand to purchase the stock if assigned.
How Cash Secured Puts Work:
- Generate Income Without Owning the Stock: You collect premiums without owning the stock upfront. If the stock doesn’t fall to the strike price, you keep the premium.
- Buy at a Discount: If the stock price falls to the strike price, you’re obligated to purchase the stock at a discount from its current price, often lower than what others would pay.
The main risk is that if the stock continues to fall, you may end up owning a declining asset. In such a scenario, the premium collected might not offset the losses from holding a stock that keeps dropping.
Which Strategy Offers Better Returns?
- Return on Covered Calls: According to experienced traders, covered calls tend to offer slightly better returns than cash secured puts, primarily due to their popularity and the positive sentiment around stocks rising.
- Return on Cash Secured Puts: While selling puts can be lucrative, the stock needs to remain stable or rise. If the stock falls significantly, you could be stuck with shares you may not want to hold.
In a comparison, a trader analyzing Nvidia's options found that the premium for a covered call was $0.72, while the cash secured put offered $0.67. Though the difference is small, covered calls typically edge out cash secured puts in terms of return.
Nvidia (NVDA)
Nvidia’s stock is currently trading at $123.72.
- Covered Call: Strike price of $130, premium of $0.72.
- Cash Secured Put: Strike price of $116, premium of $0.67.
In this case, the covered call offered slightly better income, while the put provided a potential opportunity to buy the stock at a lower price. The risk with cash secured puts is ending up with a stock that’s declining.
Coin base (COIN)
Coinbase is currently experiencing a downtrend, with its stock trading at $165.
- Cash Secured Put: Strike price of $157.50, premium of $2.74.
- Covered Call: Not preferred here due to the stock’s continuous decline.
Coin base's chart shows a 40% decline, which makes selling a put risky as the stock could keep dropping. Covered calls may not be the best strategy here either, given the stock's bearish outlook.
Which One Should You Choose?
The answer depends on your outlook and risk tolerance:
- Use Covered Calls if you already own the stock and believe it will rise slowly or stay steady. It’s a conservative way to generate income while enjoying some downside protection.
- Use Cash Secured Puts if you want to buy the stock at a lower price or are comfortable owning the stock if it declines to your strike price.
Life-Improving Tips
- Have a Trading Plan: Before you trade, know your strategy inside and out. Have rules for what to do if the stock goes up, down, or sideways.
- Consider Your Risk Tolerance: Are you willing to own a stock if it drops in price? Cash secured puts can be risky if you aren’t ready to own a declining asset.
- Learn to Exit: It’s not just about entering a trade—know when to exit. Whether you’ve sold a covered call or put, understand the right time to close out your position to minimize losses.
FAQs
- Can I lose money with cash secured puts?
Yes, if the stock price drops significantly, you may end up owning a declining stock, which can lead to substantial losses.
- Are covered calls safe?
While they provide some downside protection, covered calls cap your upside potential if the stock rises significantly.
- What happens if a cash secured put is assigned?
You’ll be obligated to purchase the stock at the strike price, which could result in holding the stock during a decline.
Call to Action
Are you ready to take your options trading to the next level? Whether you prefer the steady income of covered calls or the flexibility of cash secured puts, make sure you have a solid plan in place. Start by defining your strategy and risk tolerance, and see how these options strategies can fit into your portfolio.
Conclusion
Both cash secured puts and covered calls are excellent strategies for generating income in a bullish or neutral market. Covered calls tend to provide slightly higher returns, but cash secured puts offer the chance to buy stocks at a discount. Choose the strategy that aligns with your market outlook, financial goals, and risk appetite, and remember—having a plan is key to long-term success.
