Mon Apr 3, 2006: Sell Put Spreads Instead of Covered Calls?

Covered call option writers seek to profit from the underlying stock either staying flat or going up. Their risk is that the stock can go down.

Credit put option spread writers face the same profit or loss scenario. They make money if the stock stays flat or goes up, and can lose money if it goes down.

The difference is in the details, some of which we will look at next.

In general the major difference is that percentage gains and losses on invested principal are higher for spread writers because the leverage (and thus the risk) is greater.

Let's consider the stock of Google (NASDAQ-GOOG), currently priced at $389.70 per share. April 390-strike covered calls which expire in just 14 trading days can be sold for 17.10, which is $1,710 each. The cost to purchase 100 shares of GOOG is $38,970.

The return on the covered call assuming the stock finishes unchanged at 389.70 on April 21 is $1,710 divided by the net investment of ($38,970 - $1,710) or 4.6%.

If the stock finishes above 390 it will be called away with an additional profit of only $30 no matter how high it goes.

Please remember we're ignoring commission costs at the moment. Commission costs will reduce your net returns.

If the stock goes down, the $1,710 profit will be reduced by $100 for every point it drops, such that at (389.70 - 17.10) = 372.60 the position will be at breakeven. It will turn into a loss of $100 per point if the stock drops further.

A credit put spread could be sold instead. For example this could involve simultaneously writing (selling) an April 360 put and buying an April 350 put. At current prices this can be done for a net income of 1.80 or $180 per spread.

The margin requirement for putting on this position is the width of the spread minus the premium received, in this case $1,000 - $180 or $820 margin required. The net return if GOOG stock finishes unchanged is $180 / $820 = 22.0%. Both put options would simply expire worthless.

If the stock goes up the result is the same.

If the stock goes down but stays above 360 the result is also the same.

Below 360, the downside risk comes into play. Put on your thinking cap now!

To avoid assignment you will have to close out this spread. To close out the spread you would buy back the 360 put and then sell your 350 put.

If you sell your 350 put before buying back the 360 put then the 360 put will be naked, subjecting you to a possible margin call as well as theoretical risk of loss up to $36,000 should GOOG stock drop all the way to zero.

The 360 put you sold will have value equal to $100 for every point below 360. The 350 put you bought will be worthless unless the stock is below 350. Actually it would have some time value before it expires but for now we are only considering what happens at expiration.

Between 360 and 350, your put will be worthless and the put you sold will cost you $100 per point to buy back, with a maximum of $1,000 if it finishes in-the-money by 10 points at a price of 350.

Below 350, your net repurchase cost would still be limited to $1,000 because although the 360 put would be worth an additional $100 for each point down, your 350 put would also gain that much, offsetting the loss on the 360 put point-for-point no matter how low the stock finishes. So your maximum loss would be $820 because you received $180 income up front and have to pay off $1,000 net to close out the spread.

In addition to having to pay another round of commissions when you close out a spread, you will also have to pay "slippage" which means that your net cost will actually be more than $1,000 to close it out if the stock is below 350. This is because of the difference in the marketplace between bid and ask prices. Typically you might end up having to pay approximately $1,040 plus commissions.

If the stock finishes between 360 and 350 you will still have to buy back the 360 put even though the 350 put you owned expired worthless. The repurchase cost to close it out will be approximately $100 for every point below 360, plus slippage and commissions.

If you do not buy back the 360 put and the stock finishes below 360 you will be "assigned" on your short put. The owner will exercise his or her right to "put" (sell) 100 shares of GOOG to you at 360. Even if the current market price is much lower you will still be forced to automatically buy it in your account at $360 per share for a total purchase price of $36,000. In that case you would still get to keep the $180 and possibly also be able to sell your 350 put before it expires. Then you would be stuck owning 100 shares of GOOG, and remember you have to come up with the $36,000 to pay for it.

So as you can begin to see, selling put spreads can involve a lot more complexity than selling covered calls. There are further risks not covered here, such as the possibility of early assignment if the stock dips into the money before expiration. Please ask your financial advisor about these additional risks. I will try to explain some of them more fully in future commentaries. The point of this article was to compare covered call writing with credit put spread writing. For now I'll summarize the comparison as follows:

If the stock remains unchanged or goes higher you can earn a superior percentage return by selling put spreads. If it goes down you are subject to a potential loss of 100% of your entire margin deposit plus additional risks due to the complexities of the strategy.

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