A Smoking Option Revenue Stream: Selling Covered Calls Versus Selling Puts

Includes: MO
by: Clayton Rulli

If you are extremely knowledgeable in the options arena, then this article is not for you. This article is meant to compare the common misconception that selling covered calls is more profitable than selling covered puts. Why do so many investors utilize covered calls but frown upon put selling? They are both very similar but each do have their advantages. I also intend to show the underrated viability of the short put trade.

The Covered Call:

Usually, investors buy 100 shares of stock with a good dividend, then simultaneously or soon after sell a covered call against their position. The idea is this option they sold to collect a premium will generate additional income for their position. Let's use an example: Altria Group Inc. (NYSE:MO):

Altria has an impending ex-dividend date later this month, and is expected to pay an estimated dividend of $.44 around the middle of January 2013. The investor buys 100 shares of MO stock at $33.50, totaling $3,350. In addition to harnessing this dividend, they sell a covered call with an out of the money strike that expires after the dividend pay date. For example, let's choose the January 18, 2013 34 strike call for .35 in premium, or $35. (Total net investment is $3,315 ($3,350-$35)).

Basically, the $35 or 1.056% in premium is collected immediately but we must hold this contract and the shares for the next 6 weeks, implying a 9.152% annual revenue stream so far.

In addition to this 1.056% bonus the option creates, it also caps the upside potential of the 100 shares at 34.35 (34 strike + .35 premium), creating a max profit situation of 2.537% if shares rise anywhere above 34.00.

Now, if we add in the assumed dividend of $44 payable in January, we come up with a total revenue stream of $79. With these two streams combined, a total of 2.383% on the $3,315 investment over the next 6 weeks is achievable, not including any share appreciation.

It is important to note that the 100 shares is capped to the upside at $34/share, or 1.5% from the $33.50. So, best case scenario for this trade is shares are above 34 and the dividend is paid, in which case we could gain a maximum of $129 or 3.891% in total.

Covered Call Cash Outlay: $3,315 (100 shares @ $33.50/share -.35 in premium)
Profit Capped: $34/share,(.50 higher than current)
Revenue if Shares are Unchanged: $79, or 2.383% (Div + Premium Collected from Call Option)
Max Profit at $34/share $129, or 3.891%
Break Even Point: $32.71

This covered call strategy seems attractive, with the upside capped at $34/share, a break even point of $32.71/share, and a 2.383% total revenue stream gained.

The appeal to this trade is if shares are unchanged, the investor will still line his pockets with this earned revenue in just about 6 weeks time, as long as the dividend is paid. In contrast, let's examine selling a put contract for MO over the same time frame.

The Short Put Alternative:

MO's share price is still at $33.50/share, and we'd like to sell a put over the same time frame to compare the two trades. To earn a similar income stream as the covered call strategy above, we will sell the January 18, 2013 33 strike put for .70, or $70. We won't be eligible to collect the dividend, as we don't hold the shares. However, the positive to this is we don't have to tie up the $3,315 for the 100 shares we did in the covered call strategy. However, we will still be risking a max amount of $3,230 (33 strike x 100 -.70 premium collected) if somehow the stock implodes and shares go all the way to zero.

There are strategies where this amount doesn't have to be 100% cash. Instead, this capital could be in an alternate investment while still being accessible on Jan 18, 2013. However, this is dependent on the investor's status and the brokerage used. This possibility is a critical advantage to put selling, so it should be considered and investigated. Of course this decision is up to you, and the allocation can vary obviously.

So, we instantly collected the .70 or $70, which is comparable to the net revenue stream of $79 from the covered call and the dividend. The difference is we get this $70 instantly, and don't have to wait for the dividend to arrive weeks later. So, if we sell multiple contracts we can use this more useful instant income and deploy it into other investments, perhaps a long call on another equity, for example.

  • Now, let's compare the two trades:
Covered Call Trade: Short Put Trade:
Cash Outlay: $3,315 (100 shares @ $33.50/share -.35 in premium) $3,230 (some of this may not have to be cash in your account)
Profit Capped: $34/share $33.01/share or above
Total Revenue Stream: $79, or 2.383% $70, or 2.167% (based on $3,230 in cash)
Break Even $32.71, or a 2.358% Cushion $32.30, or a 3.582% Cushion

Notice how the short put strategy has a lower break even point of $32.30, which is 1.22% lower (from the $33.50 basis) than the covered call's $32.71. This implies the short put is a safer play, considering the 3.582% cushion is more forgiving. In addition, it's important to note the $32.71 break even point and the total revenue stream for the covered call trade assumes the .44 dividend is received. If for some reason the dividend is cut, these statistics will obviously suffer. Conversely, if MO pays a special dividend or raises the normally expected dividend, this is unexpected upside for the covered call strategy and a weakness for the short put play.

Again, it's important to verify with your broker and your option approval level, but the main advantage with the short put is the full $3,230 meant to cover the put may not have to sit in cash. Often, it can be deployed in an alternate position, but it may be needed if the put is exercised. For example, if the put is only secured by 50% cash and 50% equity, or $1,615 in cash, your cash basis changes and your profit in theory rises from 2.167% to 4.334% ($70/$1,615 cash). Again, analyzing your risk tolerance and checking with your broker for restrictions is important.

Key Differences:

The covered call strategy in this scenario can be viewed as riskier than the put since the less forgiving break even point offers less downside cushion. Also, the total revenue we calculated relies on the pending dividend to be paid. In contrast, the short put premium, while slightly less than the covered call total revenue, is collected immediately and is not subject to the risk of a dividend cut or unpaid dividend. This advantage is a simultaneous weakness, since a special dividend is a possibility over the next several weeks for Altria. The main advantage to a put is it may not be required to completely cover it with cash, but with a balance of partial cash/partial equity.

Both of these plays have their appeal. A special dividend could prove the covered call strategy most beneficial, yet the lower capital intensive put strategy has its advantages as well. When compared to a covered call, selling a put contract is an attractive alternative, and may permit lower capital requirement, therefore boosting return on a percent basis.

Disclosure: I am long MO. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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