I have written cash secured puts and covered calls in the past.  I have structured a portfolio for retirement income consisting of bonds and dividend paying stocks.  I do not want to write covered calls against the stock.  A sudden price rise would result in calling the stock and reducing my income. Is writing puts secured by the underlying stock a viable alternative.

True, writing calls on your existing holdings would generate higher initial income in exchange for the risk that those shares would be called away, reducing your longer term income stream.  In our parlance you're selling the upside on those shares, and the dividend stream that goes with it.  However, you have two choices if you do write covered calls on your dividend stocks.  Your first option would be to buy back the options before expiration and take the short term loss.  Another would be to take the proceeds of the sale at the call strike price and average into the most undervalued of your remaining dividend paying stocks, or find new dividend paying opportunities.

 Cash secured puts are another potential choice.  First, I have to point out that the payoff to a cash secured put is the same as a covered call.  In both cases you've sold the upside above a strike in exchange for the income and exposure to the downside.

 That said, I think either covered calls or cash secured puts are a good way for fundamental long term income investors to generate an income stream.  The key is to execute either strategy on stocks that you wouldn't mind holding for the long term at strike prices where you'd be happy to buy the shares.  Again, in the Morningstar framework, write the puts (or covered calls) at a strike near the five star price.  If you're income focused, you can also consider what you expect the yield to be if you buy the shares at the strike price (and assuming the dividend won't be cut).  Obviously, you'll get the most income if the shares are already below or near the five star price when executing this strategy.  You might want to look at the annualized premium measure available on the custom display controls on the options chains.

 Finally, if you have a taxable account, cash secured puts are a little more tax efficient because, if you wind up owning the shares, the put income just lowers the cost basis of the shares and you don't pay tax until you sell the shares.  Further, the put income could be taxed a long term cap gain if you sell over a year after the shares are put to you.

I hope that's not too overwhelming, but your good question deserved a good answer.

 Regards,

Philip Guziec

 

 

 

Both strategies are income drawing strategies. You are selling volatility to bring in premium. The risk of course is a spike in IV. 

Writing puts against the underlying has similar risks as that of writing calls against the underlying. The difference being the direction of the underlying. If you are short a naked call and the price rises above the strike and you are assinged, you must buy the underlying at the the market and sell it at the strike. The maximum loss is technically unlimited. When selling puts naked, the risk profile is different. If assinged, you must buy the stock at the strike and sell it at the market price. The maximum loss therefore is the strike price less premium received.

In terms of writing covered puts as an alternative for writing covered calls, just consider the various circumstances. Writing puts on owned stock theoretically decreases the price of the stock. If you buy the underlying at 50 and sell a put at 2 (with a 45 strike), you have effectively purchased the stock at (50 - 2 =) $48. If the stock decreases below the strike, say to 40, and you are assigned you now own the stock (again) at the strike price (45).

Good discussion, but I want to address this question in the OP:

 Is writing puts secured by the underlying stock a viable alternative?

I'm not sure what the OP is asking here. The quick answer is no, holding the stock does not cover a put that you sold. The only way to cover a short put is to have cash on hand. Now, you can sell the stock to raise the cash, but that's similar to having your stock called away, emphasizing the point that selling a put has a similar profile to covered calls.

Take an example. You own 100 shares of XYZ trading at $20. You sell a put with strike of $20. When the expiration date comes, XYZ is now at $10. Your put is assigned and you need to buy 100 more shares of XYZ at $20. But your current holding of XYZ is only worth $10, so you still need to raise cash to purchase more shares.

A cash-secured put is the safest way to go and I think brokers demand assets on hand as collateral in order to cover your trades.

I don't want to state the obvious, but just to clarify things, even to myself. 

 

Steve

 

 

 

[quote user="M*_Philip"]....That said, I think either covered calls or cash secured puts are a good way for fundamental long term income investors to generate an income stream.  The key is to execute either strategy on stocks that you wouldn't mind holding for the long term at strike prices where you'd be happy to buy the shares.  Again, in the Morningstar framework, write the puts (or covered calls) at a strike near the five star price.  If you're income focused, you can also consider what you expect the yield to be if you buy the shares at the strike price (and assuming the dividend won't be cut).  Obviously, you'll get the most income if the shares are already below or near the five star price when executing this strategy.  You might want to look at the annualized premium measure available on the custom display controls on the options chains.

[/quote]

I'm hoping that, in the underlined sentence above, the 'five star price' strike target applies to the cash secured puts, and not to the (parenthetical) covered calls. 

It seems to me that one could look at a cash-secured put as a limit-buy order that generates income.  Similarly, the covered-call is limit-sell order that generates income.  Obviously, the analogies are not exact, since limit orders tend to fire when the limit price is reached, whereas puts and calls get assigned when the strike price is reached and (usually) the date is close to expiry. 

Nevertheless, I find it helpful to ask myself, "Am I willing to buy (for the put) this stock at this price on the expiry date?"   If I can't answer, "Yes," then I need to reconsider the strike, the expiry date, or the underlying stock itself.  I can ask a similar question when writing a covered call.  But the prices will be different.  For the call, I would be willing to sell at the one star price.

To me this seems like swing trading on top of a long-term position — particularly so if you sell the call when the stock is at the two star price and sell the put [buying back the call if you are short there] when the stock is at the four star price.  Doesn't work for all stocks, doesn't work all the time, but when it does work, it is sweet.

Finally, I am much less concerned about assignment of calls when I and working inside my IRA, and thus not worried about preserving a long-term capital gains position.  In the taxable account, I tend to use roll-outs to avoid assignment of a stock I have owned for a while.
 

I guess the first thing that came to mind was simple: "If you don't understand the mechanism of puts, you have no business writing them." There is no such thing as using a stock to offset or underly puts. Puts are an OPEN ENDED commitment, whose only safety net is the strike price. If you own a thousand shares of Stock X trading at 30, and sell 10 puts with a strike price of 25, you have zero protection. If X goes to $25.01, you keep the premium and own a thousand shares of Stock X that has depreciated $5k.

 

If, on the other hand, Stock X goes to $3, you now get to BUY 1000 shares of Stock X at $25, costing you $22K.  That and your underlying has now lost $27k. Hope the premium was worth it. Stay out of options.  

 

I have heard of older investors selling puts, believing the rich premiums are found money.  Well, one downturn and you have lost money. The only consistent money I make on options is writing covered calls, and occasional puts on market trends ( I started buying MBIA puts at $40 underlying. 

ernie,

You seem to imply that writing covered calls is much safer than writing puts, but that is not the case at all. In fact, they are quite similar. If you write a covered call and the stock price drops a large amount, what is the difference between that and having the buy the stock at the put strike price? Nothing. You still lost money. That's why it's important to select stocks that you are comfortable with and know something about them. Stock selection is critical.

Writing cash-secured puts and writing covered calls are just two ways to do the same thing. Some people prefer covered calls and some prefer writing the puts. It's what you're comfortable with and what your experience is like. But of course, the premium in either method is not "free" money at all, so that needs to be considered. In the case of a covered call, you are giving up upside potential and lowering your cost of the stock. If a written put is exercised, you end up buying the stock, but your premium discounts your cost there as well.

You mentioned that what a bad deal it would be if you sold a put with a strike price of 25 on a stock, and the stock price plummets to something like 5 bucks. OK. But there's no difference between that scenario and holding onto the stock in a covered call position as you watch the price fall to 5 bucks. Remember, you can also take action in any position to cut losses. You can roll down in the covered call, and you can also roll your put position as well.

That is nice about options.... you have the option to change it at any time.

JMHO

Steve

 

 

Steve: No intention of implying there are similar or dis similar risk profiles or that one is preferable. My response was to the poster who thinks his underlying stock is somehow a magical offset to risk.

 

I write covered calls on appreciated stock, as insurance and for income. I do not write naked calls, and have written a few naked puts. I don't consider naked put writing a reasonable tactic for retired folks. I take that back, I have written naked calls on stock liek LDK.   

OK Ernie, thanks for your clarification about your own experience and tactics.

Talking about risk, I'd never write a naked call. My broker doesn't even allow it. I do write cash-secured puts, so I guess that's not naked. And you're right, simply owning the underlying stock has nothing to do with writing puts.

Thanks for keeping the forum active. Not too busy around here lately. I think we'll get more posts as M* writes new articles for their Options section.

Steve

 

 

I'm a pessimist, you're an optimist  LOL!

Philip,

 

That was a great answer Indeed. How can I find out more about the Morningstar Framework and any white papers on writing puts that you have authored or would recommend as valuable reading?

 

Michael Fitzmaurice

I'm a little confused with your question and the response. If you write an option contract this means that you are selling an option contract. Which means that you will receive an option premium and have the OBLIGATION to perform. Under under your scenario you are writing/selling an obligation to purchase the underlying security at a specified price anytime during the life of the option.  To protect the value of the stock in your portfolio you should purchase (BUY) puts which will provide you with the opportunity NOT THE OBLIGATION to PUT your stock to the option writer.  This will provide you with downside protection at the sametime providing you unlimited upside potential.  Under your scenario the purchase of a PUT option is like buying insurance for a specific stock. The question to answer is the insurance cost worth it? I hope that I have not confussed the issue. I have the following axium that helps me.

If I receive $ = I have an obligation to perform.

If I give $ = I have a right to make someone perform.

Below is a definition of a PURCHASED PUT AND NOT A PUT THAT HAS BEEN WRITTEN.

Put

An option contract that provides the owner the right (but not the obligation) to sell a stock

at a specific price (also called the strike price), over a given period of time. 

I have been following this thread a bit, and would like to understand the things to bear in mind before writing a covered call. To give you a background of my position, sometime back I bought growth stocks but it has been sliding thanks to recession fear. I would like to hold on to the stocks for a long time, but during the time, I would like to write covered calls to protect some of the down slide. How do I determine the period, strike price.

The stock is currently trading 10% below the M* 5 star buy price. What is a reasonable period for which I can write the call? What are the usual exit or risk minimizing strategies after writing a call?

 

thanks

kris
 

 

[quote user="kris_fin"]

I have been following this thread a bit, and would like to understand the things to bear in mind before writing a covered call. To give you a background of my position, sometime back I bought growth stocks but it has been sliding thanks to recession fear. I would like to hold on to the stocks for a long time, but during the time, I would like to write covered calls to protect some of the down slide. How do I determine the period, strike price.

The stock is currently trading 10% below the M* 5 star buy price. What is a reasonable period for which I can write the call? What are the usual exit or risk minimizing strategies after writing a call?[/quote]  

If you are using an online broker and already have the ability to write covered call options in your account, you can probably find an area on the web site where premiums are quotes based on strike price and expiration.

Keep in mind that in a rotten market like the current one -- one where pessimism and uncertainty rules the roost -- covered calls aren't likely (in most cases) to bring near the premium as you would see in a stronger, more optimistic market (such as tech stocks in 1999).  The longer the time window until expiration, the higher the premium will be.  Similarly, the *lower* the the strike price in a covered call option, the higher the premium will be.

As far as writing the call goes, the only "risk" is that the stock will rise above the level of your strike price and you will have the options exercised, taking you out of additional gains (and it may trigger a taxable event, too, which is something to keep in mind if you're not doing this in an IRA).  That's one way to "exit" a written covered call.  Two other ways would be to sell the options contract before expiration (which could be at a gain or a loss), and for the option to expire worthless (in which case you made a gain on the writing of the call, and you still have the stock.  

 To my knowledge there is no "magic" advice for what level to write a covered call for.  If a stock is currently at 100 today, you may be comfortable writing a covered call at 110 to expire in June.  If the option is exercised, you gain the option premium plus the 10% gain on your shares.  (Heck, right now ANY gain, let alone 10% plus the premium, sounds good!) 

Kris,

You mentioned that you plan to hold on to these stocks for the long haul and want to write calls to gain some downside protection. That is fine, but IMHO, if you write a covered call (CC), you MUST be WILLING to sell that stock at the strike price, period. CCs are not free money, they have an obligation too. So if you write a call, write at a price level that you would be comfortable letting go of the stock. Now, the premium received from this obligation will lower your cost basis and increase profits on the stock, but you have to realize that if the stock rebounds strongly beyond the strike price, you may be wishing you never even heard of covered calls.

For me, having a stock assigned is good news because I have realized my maximum profit when I planned the position. I do not dwell on the fact that I might have made more money. I am just grateful that I made money, which is a whole lot better, as Cramer would put it, than a sharp stick in the eye.

Once you write a CC, IMHO, you no longer have a stock position and an option position, you have a whole new breed of animal, and that is how I look at it. I look only at the entire entity. If you cannot accept letting go of your stock, then do not write CCs.

 

JMHO

 

Steve

 

I'm a writer for Kiplinger's and I'm looking for someone who uses put options to safeguard embedded gains, and who would be willing to be interviewed for the magazine.  If anyone on this thread has any experience with this and would be willing to be interviewed, please contact me at Eody@kiplinger.com, thanks.