I enjoy the terminology of the stock market. You have puts, calls, spreads, momentum, theta, beta, gamma and everything in between. But sometimes this terminology can be misleading, take the friendly sounding 'covered call' and compare it to the scary sounding 'naked put.' A covered call is like something your best friend in high school would promise you: "Don't worry man, I got you covered." While a naked put sounds like something strange and demeaning. I'm not going to elaborate here, use your imagination. Given this verbal dissimilarity, it would probably surprise you to know that writing a covered call and selling a naked put are nearly the exact same trade!
Let's say I own the SPDR S&P 500 index fund (NYSEARCA:SPY), which trades for $152.11 per share. Then I sell a Jan-2014 call option with a strike price of $153 and a premium of $7.20. If I owned 100 shares of SPY to cover my call I would have spent $15,211 and collected $720 for the selling the option, a net cost of $144.91 per share. The graph below shows my theoretical gain and loss from the trade at expiration. If the market goes up it does not matter how much, I will earn a profit of $8.09 (the premium plus the amount the option was out of the money) or 5.58% on the $14,491 I had put at risk to enter the trade.
But what if I set up the exact same trade through selling a put instead? A $152 strike Jan-2014 put sells for $10.18. Let's say I had the cash to make the purchase, but I wanted a lower my entry price. I don't want to chase the market higher, but I don't want to sit in cash in the meantime. So I sell the put mentioned above and I collect $1018, I must have $14,182 in cash to cover the trade, but now I hold $15,200 in cash. What is my gain or loss on the trade? Again the SPY must trade down squeezing my profit until at $141.82 I am just breaking even. Below that price all the downside is mine to bear. In this case I have risked $14,182 and been paid $1018 for my trouble or 7.17%.
So which is the safer trade? Selling a naked put is the superior trade because the breakeven price is lower and the profit on at risk capital is higher. Now some of you may be thinking: what about the return from dividends I would receive for holding SPY? The last quarterly dividend for SPY was $1.02 or $4.08 annually. However, this yield is only 2% and I already established that I would be holding $15,200 in case my puts are executed. There are any number of very conservative fixed income funds that will pay an equal amount relative to the dividend yield of SPY, thus the issue of dividends is moot.
The major difference between writing a covered call and selling a naked put is that through holding the stock you are able to collect the dividend in the meantime. Thus, covered calls can be an effective way to collect an added premium in addition to the dividend. However, it must be noted that this is not a free lunch; the holder of the stock retains all the downside, just as the seller of a put does. Imagine that I practiced a covered call strategy for the SPY each year since 2000 and assume the premium is the same relative to what it is now (unfortunately I do not have access to historical options data).
If on the first of January each year since 2000 you entered a covered call trade you would have lost 23% of your capital. You realize a small gain if the market goes up, but at the expense of a large loss if the market goes down. Of course selling puts would have the same disadvantage if as soon as the shares were assigned you sold for a loss and opened another trade. However, since the premium paid for the put is higher executing this strategy would have lost approximately 7% of your capital rather than 23%. Both exclude dividends, but the put strategy would have outperformed in this regard since the yield on a risk free bond exceeded the dividend yield of the S&P 500 over this time period.
Several conclusions are important:
- Whether you are selling a put or writing a covered call the goal must be to continue hold the stock if the put is exercised or if the call expires worthless. Both strategies simply serve to lower your entry price.
- Selling naked puts is less risky because the higher premium lowers your entry point more. A lower entry point is safer.
- The major difference between the approaches is the covered call captures the dividend. This can be a reasonable strategy, but my preference would be to put the strike price deeper in the money. This lowers your cost-basis more if the call expires worthless and you experience a loss.
While a covered call strategy can be viable for stocks paying high dividends, it is generally inferior to selling naked puts. This is because the premium paid for a put now significantly exceeds that of a call as the above example for SPY illustrates. While writing covered calls for high dividend paying stocks, such as AT&T (NYSE:T) can be attractive, the incredibly low premiums for these calls mean that there is still significant risk. For example, in order for an AT&T call to have time value the lowest strike price Jan-2014 call available is $35 for a premium of $2.15. The $1.14 time value means the owner will not execute in the near term and you can expect to collect the dividend, however, you will have all the risk should the stock fall below $33.85. Over one year assuming the trade began before the first quarter ex-dividend date, the maximum upside will be 4 quarterly dividends of $0.45 plus the time premium when the contract is executed or $2.95 total. Thus, the maximum gain is 8.7% and because you collected four dividends your cost basis if the call expires worthless is $32.05 representing a buffer of 11%. Thus for high dividend stocks the covered call strategy can be viable because collecting the dividend over time reduces your risk and adds to the potential return.
In many cases these incredibly low time values for LEAP calls on dividend paying stocks make purchasing calls very attractive. Stocks that have cheap LEAP calls include: ConAgra Foods (NYSE:CAG), General Mills (NYSE:GIS), Johnson & Johnson (NYSE:JNJ) and Exxon Mobil (NYSE:XOM). This strategy is even more attractive if the company is presently repurchasing stock as holder of the call option stands to pocket all the upside felt from a shrinking share count.
As shown above, the covered call strategy is friendly in name only. Premiums are so low relative to puts that selling naked puts is more attractive at the present time. Furthermore, holding stock an unpaired trade is less risky as the past twelve years have illustrated. At least if the market continues to go up you have something to gain, once you sell your upside you have a small known gain, but a large potential loss. It may feel good to collect a premium, but over time that small premium is not adequetely protecting you against years when the market declines.
In many cases names can be deceiving and this is certainly the case for covered calls, as the recent past has shown they are far riskier than most investors believe them to be.
Disclosure: I am long CAG, GIS, JNJ, T, XOM. 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.
Additional disclosure: For CAG, GIS, JNJ and XOM I am long LEAP calls, while for T I own shares but I am short LEAP calls.