Wednesday, May 20, 2009

Covered Calls Versus Cash-Secured Puts

Is it preferable to invest via covered calls(CCs) or cash-secured puts(CSPs)? Many books and website resources on options correctly indicate that these two strategies are 'synthetically equivalent'. In other words, the profit and loss profiles of the two strategies are essentially identical when positions in the same underlying security are established at the same moment in time, at the same strike price, and for the same expiration date.

The equivalence of these two strategies can be demonstrated mathematically. The symbols used below are:
S=Stock
C=Call
P=Put
Further, being long a position is indicated with the + symbol and being short a position is indicated with a - symbol. For example, owning a stock would be +S.

The foundational equation that describes the relationship between stocks, calls, and puts is:
+S = +C - P
That is, a long stock position is equivalent to owning one call and shorting one put (when the strike price and expiration date are identical for the call and put).
Looking at the equation above, we can determine this as logically true since at expiration:
- If the long call is in-the-money(ITM), the call is exercised and converted into long stock at the exercise price. The out-of-the-money short put expires worthless.
- On the other hand, if the long call is out-of-the-money(OTM), it expires worthless. In this case, the short put is in-the-money and it is exercised and converted into long stock at the exercise price.
Also from the equation above, after moving the +C to the other side of the equation, we would have:
+S -C = -P
Voila! The mathematical equivalence between the two strategies is now evident since the left side of the equation is a covered call (i.e. long stock with at short call) and the right side is a short put.

During the past several weeks, there has been a lively discussion on the Yahoo!Groups JustCoveredCalls site on the relative merits of covered calls versus cash-secured puts. This discussion has motivated this Covered Calls Advisor to take a fresh look at the circumstances that might cause one strategy to be slightly preferable to the other. Although this advisor has maintained a long-running commitment to covered calls investing, it is important to remain open-minded to the possibility of a better investing process. First however, to improve clarity in advance of the remainder of this article, let's consider the difference between a 'cash-secured put'(CSP) and a 'naked put'(NP). A 'cash-secured put' assumes that the investor maintains sufficient cash collateral in their account to fully fund the purchase of the stock if the put is assigned to them. On the other hand, if margin is used because the investor chooses to leverage their short put position with less than 100% cash collateral, then the term 'naked put' is appropriate.

Although the math above demonstrates the essential equivalence of covered calls with cash-secured puts, there are some subtle distinctions that slightly favor CSPs and others that slightly favor CCs. They are:

I. Advantages of Selling Puts

A. Applies to Selling Naked Puts (On Margin)
1. In a taxable account, leverage can be used by investing via margin, which enables a significantly lower initial investment than for either a cash-secured put position or a covered call.
2. In a taxable account, if margin is used, no margin interest is involved.

B. Applies to Both Naked Puts and Cash-Secured Puts
1. Primarily as result of the cognitive bias known as 'loss aversion' (or fear factor), the implied volatility of the put option (IV-Puts) will often be somewhat higher than the implied volatility for its counterpart call option (IV-Calls) and thus offers a somewhat higher potential return-on-investment(ROI) %. Note: 'Loss aversion' is the tendency for people to have a stronger preference for avoiding losses compared with acquiring gains. Research has shown that losses can have as much as twice the psychological power as gains. It should be clearly understood however that any put-call parity deviations are normally relatively slight since any persistent substantial differences would present an arbitrage opportunity to be taken advantage of with a risk-free trade.
2. Slightly lower commissions – One transaction to establish a short put position, but two to establish a covered call position.
3. Earn money-market return on secured cash balances.
4. For OTM CSPs – lower initial investment provides somewhat higher potential ROI % if exercised.
5. Advantageous if want to buy a stock only if there is a price pullback.

II. Advantages of Covered Calls

1. Primarily as result of the greed factor, IV-Calls will sometimes be somewhat higher than IV-Puts thus offering a somewhat higher potential ROI %. Of course, the disclaimer described above regarding put-call parity deviations for CSPs also applies as well for CCs.
2. There is:
a. A positive abnormal performance in stocks with relatively expensive calls (IV-Calls > IV-Puts); and
b. A negative abnormal performance in stocks with relatively expensive puts (IV-Puts > IV-Calls).
Source: "Deviations from Put-Call Parity and Stock Return Predictability" by Cremers and Weinbaum.
3. Simplicity— That is, use only one strategy (CCs) rather than two (CCs and CSPs). For this Covered Calls Advisor, it is more difficult to easily re-orient my thinking between the two strategies -- while one strategy is in-the-money, its equivalent counterpart strategy is out-of-the-money. In thinking about a particular position, the mental gymnastics to convert between CCs and CSPs is inconvenient at best. For me, it is simply easier to conceptualize CC positions than for CSPs.
4. Better clarity in understanding available cash balances in brokerage accounts – thus a reduced chance of:
a) Unintentionally dipping into margin; and
b) Unintentionally overextending your margin limits.
5.Potential for dividend income (although dividend amount already included in option premium).
6.For OTM CCs – lower initial investment provides somewhat higher potential ROI % if exercised.
7. Advantageous if want to own the stock at its current price.
8. No need to wait 3 days for cash settlement from prior transactions before establishing new covered calls positions.
9. Better pricing visibility on our online brokerage accounts: (a) CSPs do not show on account portfolio diversification tables; and (b) With CSPs, we only see option prices. Not seeing the current price of the underlying security makes position management (such as rolling) decision-making more difficult.

Almost all of the items presented above provide only a modest relative advantage of one strategy over the other. However, the one item that potentially provides a more significant advantage is the selling of Naked Puts. All other factors being equal, by using margin, the NP investor has an opportunity to increase a CC or CSP return by a few incremental percentage points. And this approach might be acceptable for some investors -- but, as indicated in a prior post (link), "the Covered Calls Advisor is strongly opposed to margin account investing." From my experience, margin investing imposes unnecessary additional stress on the investor. This tends to distort the calm, dispassionate temperament needed for our investment decision-making process. For this advisor, the potential for returns deterioration associated with this disadvantage more than offsets the potential incremental returns advantage that might otherwise accrue from leveraging NPs.

A direct comparison of the advantages of CSPs and CCs listed above does not reveal a clear advantage to either strategy. But based on the preponderance of the evidence, the Covered Calls Advisor continues to be more comfortable investing with covered calls.

This topic is more complex than most postings on this blog. If you have questions or comments, please feel free to submit them -- they are always welcomed. Click the 'comments' link below or post them on the justcoveredcalls Yahoo!Group site. If you prefer confidential communications, my email address is listed at the top-right sidebar of this blog site.

So for now, this blog site motto remains: "Stick With Covered Calls"!

Regards and Godspeed to All,

Jeff

7 comments:

  1. Jeff,

    Have you looked at Dignoal Leap Spread (DLP) in-lieu of just covered call (CC)?

    Thanks,

    Mike

    ReplyDelete
  2. Mike,
    Yes. Several years ago I did some investing with DLPs but I found CCs to be slightly more profitable. I think this is primarily because it is better to buy appreciating assets (think stocks) and sell depreciating assets (think calls, puts, LEAPs).
    Jeff

    ReplyDelete
  3. In the first paragraph you compare a call and a put written at the same strike price.

    Would one of the options be sold ITM while the other is sold OTM?

    Or would the same difference be used?

    For example, if the underlying is trading at $12.50 would the $13 call and $12 put be sold?

    Thanks,

    techphets

    ReplyDelete
  4. Also, could you elaborate on CSP #2:

    4. For OTM CSPs – lower initial investment provides somewhat higher potential ROI % if exercised.

    and CC #6

    6.For OTM CCs – lower initial investment provides somewhat higher potential ROI % if exercised.

    I read this as a comparison between CSP and CC but for those two I'm a bit confused since they same the same thing.

    Is #4 comparing OTM CSPs with ITM CSP while #6 compares OTM CCs with ITM CCs?

    Thanks.

    ReplyDelete
  5. Hi Jeff,
    I just recently started to follow you and have found your style and approach in line with what makes sense to me. I do have a question for you...
    In your posting from May 2009 you stated you will stick with CC. I have noticed that you now engage some cash secured Puts. What motivated you to modify your earlier position on CC only? Is it market driven, formula driven, or other new insights? For example, why did you choose to sell Puts on HIG rather than a CC?

    ReplyDelete
  6. Carter,

    Good question.

    As you know, covered calls and cash-secured puts are synthetically equivalent positions when done at the same strike price and for the same expiration date. Normally, the put/call parity is extremely close and no arbitrage opportunity exists between them. But not always.

    Before establishing a position, I compare the implied volatility of the calls and puts for the same strike price and expiration date. Normally, they are very close in which case I will initiate a covered calls position. But I've noticed in some instances, especially it seems when there has been a recent decline in the underlying stock price (note: this was the case in the HIG example you cited), the IV of the puts exceeds that of the calls. I surmise that this temporary situation is primarily because of the fear factor associated with the declining stock price and a large demand to buy puts (as protection against a potential further decline). This may result in a temporary inflation of the put premiums relative to that of their comparable calls. Since we are options sellers, I try to take advantage of this temporary disparity by selling the higher-priced premiums available in the puts.

    Jeff

    ReplyDelete
  7. Helpful info. Can you detail how you measure iv of a call or put?

    ReplyDelete