Fri Feb 10, 2006: Elan Corp. (NYSE-ELN) Covered Put Comparison

Writing covered put options can provide a high-yield income stream while reducing the risk of selling a stock short.

The risk of short selling is that if the stock you sold short goes up, you lose money. But with covered puts at least you get to keep the option income, because if the stock goes up then the puts go down. Either they expire worthless (if they finish out-of-the-money) or you can buy them back at a profit (if they are still in-the-money).

Let's compare two possible covered put writes for ELN stock, which closed today at 14.08 per share. For the sake of simplicity we'll assume 100 shares and just one option contract, and ignore commission costs and margin interest.

First of all selling 100 shares short at 14.08 requires a 50% initial margin deposit of $704. Then selling ("writing") a March 12.50 put option at today's closing bid price of 1.30 would provide an income of $130 or 18.5%. Not bad for one month, assuming the stock stays unchanged.

If the stock closes below 12.50 on expiration day Friday March 17th then you will be assigned on the put. That means the put buyer will exercise his option to "put" (sell) 100 shares to you at the strike price. So you'll be forced to (automatically, handled by your broker) buy 100 shares at 12.50, which is actually a good thing because remember you sold them short at 14.08! That's why we call it a covered put - you can't lose money on the put no matter how far the stock drops because your short position will offset that loss and you don't even have to buy the put back anyway, you can just let it be assigned. The additional "bonus" profit of 14.08 - 12.50 = 1.58 per share or $158 would make your total income $288 or 40.9%.

If the stock closes at 12.50 or above then the option simply expires worthless, and the following Monday March 20th you'll be able to sell a new covered put for April. The ideal situation for covered put writers is to keep pulling in more income every month without the stock going up. Be aware though that if it does go up not only is there a loss on the short position, but also the amount of money you can get for selling the next month's put option will be less.

One way to handle this situation is to sell a two-month or three-month option next time. That is, after the March put expires worthless if the April put is not paying a high enough premium to satisfy your desired income level, you could sell a May or June put. Realize of course that the income you receive will obligate you for two months or three months so the yield will have to be divided by two or three if you want to compare it on a monthly basis.

Selling one-month options typically provide the highest average monthly income, but the least amount of certainty since if the stock goes up then puts are not as high-priced the next month. Selling multiple-month options can lock in a known income for the put writer over several months.

Another approach is to sell an in-the-money put option. At today's closing bid price of 2.45 or $245 per contract the March 15.00 puts provide a similar one-month income yield compared to the March 12.50 puts, with less risk. The risk is less because even if the stock goes up to 15.00 there is no net loss on the short position; it's offset by the in-the-money portion of the put option premium.

Since this put is in-the-money by 0.92 the time value of the option is 2.45 - 0.92 = 1.53 or $153 per contract. This is a yield of 21.7% versus the 18.5% for the 12.50 put (slightly better even with less risk!). If the short stock is put back to you at 15.00, which would happen if the stock is anywhere below 15.00 on expiration day, then the 0.92 in-the-money additional income portion would be cancelled out by an equal loss of 0.92 on the stock. That's why you can't count the entire 2.45 as income.

Notice that the stock can go up by as much as 92 cents per share without affecting your yield at all. That's why when selling short, in-the-money put options are safer to write. The disadvantage is if the stock goes down there is no additional "bonus" gain for you like there was by selling the out-of-the-money 12.50 put. For investors focused primarily on income, this is not their major concern.

Remember that when you sell a stock short the risk of loss is unlimited because the stock could keep going up and up. For this reason covered put writing is more risky than covered call writing, where at least you know the lowest the stock you own can fall is to zero.

With many stocks currently at very high levels after a three-year bull market run, I will be commenting from time to time on additional bearish strategies for those investors looking to profit from downside moves, or from a flat market. Oh, how we option writers dream of flat markets, with lofty option premiums as far as the eye can see! If only it were that simple.

Until next time, best of luck with your option investments!