OPTIONS TRADING
Covered Calls, Cash-Secured Puts, Or Credit Spreads?
The pros and cons of three popular strategies.
Covered calls, cash-secured puts, and credit spreads are wildly popular strategies for selling options.
And for good reason.
All three can instantly turn cash or shares into cash flow. And depending on your life situation and risk tolerance, they can be a significant source of income.
But is there a clear winner?
And more importantly, are there any big, bright red flags to look out for?
We’ll cover all that below. First, a quick-and-dirty primer on these strategies.
(By the way, if you’re totally unfamiliar with options, then this intro is a more approachable starting point.)
I’m not a financial professional. This is purely opinion and entertainment, not advice. Do what’s right for you, and if in doubt about what that is, then it’s important to find someone who’s legally able to tell you.
What is a covered call?
I’ve covered this at great length, but here’s the condensed version:
- You hold at least 100 shares of a stock/ETF. This is the collateral.
- You write (i.e., sell to open, or “short”) an out-of-the-money call option for a strike price at which you don’t mind selling the underlying shares. The premium on this contract is the source of cash flow.
- If the call is in the money at expiration (or, rarely, a little earlier) then you’re “assigned” to sell the shares. That happens automatically. Your profit will be
strike price - purchase price + premium collected. - If it’s out of the money, or if you close it early, then you’re not assigned. You keep the shares and are free to write another call. However, your cost basis (average cost of the underlying shares) has been reduced by the amount of premium collected.
In brief, you’re selling someone the rights to any upside beyond the strike.
What is a cash-secured put?
A cash-secured put is effectively the mirror image of a covered call.
- You hold enough cash in your brokerage account to put 100 shares of a stock/ETF. This is the collateral.
- You write an out-of-the-money put option for a strike price at which you don’t mind buying the underlying shares. The premium on this contract is the source of cash flow.
- If you’re assigned, then your brokerage automatically uses that cash to execute the purchase.
- If you’re not assigned, then the cash is freed up to use for more puts or whatever else you like.
In brief, you’re selling someone insurance against their shares dropping below the strike.
What is a credit spread?
A credit spread refers to simultaneously buying and selling options at difference strikes (creating a spread) for a net credit to your account.
It works with a pair of puts or a pair of calls. But instead of collateralizing your own shares or cash, you collateralize a long option.
This is a little more complex, but here’s the gist of it:
- You open a margin account, which all brokers require for selling spreads.
- You choose a strike price that you think the underlying won’t rise above (call) or drop below (put). This is the short strike, i.e., the strike for the option you’re going to write.
- In the same order, you buy an option at least one strike higher (call) or lower (put) than the short strike. This long option must be of the same type—call or put—as the short option.
- You can wait until expiration, but it’s best to close the position earlier to avoid surprises around assignment. (That’s a topic for another day, but in brief, it’s trickier to handle assignment when your collateral is another option, not shares/cash.)
In brief, you’re a) selling insurance against their shares rising above or falling below the strike and b) buying reinsurance against a major “claim.”
That was a whirlwind explanation, but it would take a couple thousand words to do justice to any one of those strategies.
But if the general principles make sense, then let’s keep going!
The pros & cons of selling options
All three are viable strategies that I’ve employed for nice returns on capital over the last couple years.
The beauty is that you can profit even without being correct about where a stock’s price is going. You just have to be correct about where it’s not rapidly going.
Still, these strategies are sometimes inappropriate and always have drawbacks.
That isn’t necessarily a problem. Every tool in your toolbox has its uses and limitations. Knowing them is the only way to pick the right one.
Advantages of covered calls
Covered calls feel like free money; I refer to them as “DIY dividends” in another article. That’s a little glib, but not wrong.
They’re a terrific introduction to selling options, since there’s little risk besides opportunity cost (more on that a little later.)
If you’re conservative with strike prices (think 0.15 delta or even less), you can effectively double or triple the dividend yield with minimal risk of assignment.
At that level of risk, your average monthly premiums might equal about 1% of the underlying equity. For instance, on a $10,000 underlying positions, something like $100 per month in covered call premiums is a reasonable expectation. It’s not that consistent in reality, but it’s a decent rule of thumb.
And for positions you wanted to sell anyhow, you can pick a closer strike in hopes of assignment, and think of the premium as a little going-away present.
What’s more, if you can’t help but trading trendy companies or meme stocks, then the high implied volatility means high call premiums. Unlike the other bag-holders, at least you’ll get a consolation prize…
Disadvantages of covered calls
The primary issue is that covered calls deprive you of any major upside. Sure, you could choose a strike 30% out of the money on a blue-chip stock, but the premium will be negligible (if it’s even traded at all).
Once in a while, something big happens. The share prices takes off to the moon, and you either get assigned and miss the upside or close/roll the position at a high cost. Those are the only choices, and neither is ideal.
It’s also tempting to get into volatile shares just because the call premiums are high. This isn’t a fault of the strategy itself, but it’s a temptation you’ll need to actively avoid.
To illustrate, let’s say you just bought 100 shares of Stonks Inc. at $8/share, after it shot up from $1 following an Elon tweet.
The good news is a covered call at a $9 strike might return $1/share in premium in a month, plus $1/share in capital gains if assigned. That’s an incredible return if it happens.
The bad news is the incredible return is possible only because there’s virtually no chance Stonks Inc. still trading at $8 or $9 in a month. The odds are overwhelming that it either a) goes to the moon, so you miss out on following assignment, or b) burrows deep under the earth’s crust, so you’re a bag-holder with a little premium as a piddling consolation prize.
True, perhaps the premium means you only lost 80% instead of 95% like everyone else on Wall Street Bets, but you’re holding the bag nonetheless. Just say “no” to meme stocks, with covered calls or otherwise.
Advantages of cash-secured puts
Cash-secured puts are a terrific way to earn a little bit while you wait for a stock to reach a price you like. If that price is only a few percent below the current market price, then the premiums are well worth it. (That threshold might be 3% for some companies and 20% for others; it all depends on volatility.)
In other words, it’s a great approach for stable companies you already wanted but consider temporarily overvalued.
And for more volatile stocks, cash-secured puts that avoid assignment can help you profit from volatility without having to watch your equity potentially vaporize. You may still be in for a wild ride, so I don’t recommend trading highly volatile assets or their derivatives in the first place, but at least it’s not the worst way to get your gambling fix.
Disadvantages of cash-secured puts
There’s always the chance that what you consider “temporarily overvalued” is simply the company’s new baseline leading into years of 20% annual growth. In that case, you may never get assigned. Simply buying shares is probably wiser if you’re that bullish.
If you’re only OK with being assigned at a strike far below the market price, then you’ll have to accept a negligible premium despite tying up a lot of collateral. What’s more, if the shares actually hit a strike that began so far out of the money, there may be serious issues that make the whole company seem like a bad buy.
You can always roll the position to avoid assignment, but it won’t always be profitable. And if the bad news seems permanent—like fraud or a regulatory change—then your cash will be tied up as you roll that put for a long, long time. (At that point, I’d probably just close it for a loss and put the cash to more productive use, but it all depends.)
Finally, the earlier caveat about chasing volatility applies to cash-secured puts, too. Sure, I’d rather collect a premium as my meme stock equity disappears than not collect a premium as my meme stock equity disappears…but better yet, I’d rather not go there in the first place.
Advantages of credit spreads
Covered calls are based on shares you bought.
Cash-secured puts are based on shares you wouldn’t mind buying.
But credit spreads are deliberately constructed so you never touch the underlying shares. As long as you close them before expiration (and usually even if you don’t), you trade nothing but the options contracts themselves.
For one thing, that makes them appealing if you like the insurance and risk aspects of options but don’t like researching businesses.
You don’t and won’t hold the underlying, so their financial statements and competitive advantage and whatnot don’t make much difference. Just avoid earnings (in my opinion) and stick with highly liquid, large-cap companies whose prices are quick to incorporate news.
What’s more, they’re extremely capital-efficient if option premium is your only goal.
A long options contract is far cheaper collateral than shares or cash reserves. It costs just a fraction of the share price. (Of course, it’s volatile and decaying collateral with an expiration date, so risk increases too.)
Capital efficiency is critical if you’re entering the position just for the sake of option premium.
If you already had or wanted the underlying for its own sake, then that’s another story. The shares are the goal and the premium is a bonus.
But if the shares are just the means to collect premium, then you’ll stretch your cash much farther by selling credit spreads.
(As an aside, the popular poor man’s covered call works along these lines. It involves writing a call as with a regular covered call, but substituting a long-term, high-delta call in place of shares. It’s not a credit spread due to time and strike prices differences, but it’s a quintessential example of using long options as capital-efficient collateral.)
Disadvantages of credit spreads
I love credit spreads and have enjoyed solid returns with them for over a year. I’d even go as far as to say they’re the most capital-efficient point for very small trading accounts (under ~$5k).
But they have a few serious limitations.
Above all, they’re harder to roll. If the stock price moves uncomfortably close to (or past) your strikes, then you generally need to roll the position to avoid a potentially large loss.
The thing is, you’ve got to roll two contracts instead of one. You’ll pay twice the fees, and depending on liquidity, you might lose twice as much in the bid-ask spread.
The obvious solution is to stick with highly liquid yet fairly stable stocks. High premiums are tempting, but the difficulty of rolling (or at least rolling for a credit) makes me reluctant to sell spreads on more volatile underlyings.
I mentioned at the beginning of this section that spreads are capital-efficient. For instance, it’s common to return $10-$100 on just $500 in collateral. But that means that a hypothetical $5k account could load up on ten $5-wide spreads versus at most a couple covered calls/cash-secured puts.
That’s worrisome, since there’s probably some correlation between your positions. Crazy news might only affect one firm, but if broader market dynamics plunge or boost one underlying, then chances are all underlyings will make a related move. That can push you into max loss territory (or at least costly rolls) and tank the whole account.
So, especially with credit spreads, fight the urge to trade big!
Along those lines, you can’t directly recover losses on a credit spread.
If you’re assigned on a cash-secured put and the underlying subsequently plummets, then you can simply hold the shares as they recover. You can even sell covered calls (at/above cost basis) to recuperate the paper losses. (You did choose an underlying you actually wouldn’t mind owning, right?!)
And covered call assignment only incurs opportunity cost. You’re missing out on upside, but unless you chose a strike below your cost basis, you’re still up.
But there’s no such opportunity with spreads, precisely because you never touch the underlying shares.
The bigger picture
I enjoy generating cash flow with options. It’s been engaging and financially rewarding to sell CCs, CSPs, and spreads.
But they don’t and can’t replace long-term investment.
Whatever combination of these strategies you use, it’s important to funnel some of the profits into assets.
Which assets? That’s up to you. I prefer dividend growth stocks and real estate (via Fundrise), but your resources and goals may point another direction.
Regardless, the point is to start with the end in mind. That sounds cheesy, but if your goal is steady long-term cash flow, then prioritize long-term assets from day one.
That can be as simple as using half the premium you collect to build up options collateral, then using the other half to buy shares in an index fund (or whatever asset you’re ultimately bullish on).
