By Lawrence G. McMillan
This article was originally published in The Option Strategist Newsletter Volume 15, No. 15 on August 10, 2006.
In the past couple of months, we’ve published several articles dealing with covered call writing and some of its companion strategies – naked put writing or put credit spread trading. Two issues ago, the feature article addressed some of the ways that potential bear market risk affects popular strategies, including covered writes. In addition, several of the Covered Writing articles (that usually appear on page 5) have discussed various aspects of naked put selling and credit spreading. We have also received a number of inquiries about these alternate strategies from current and potential money management clients. Therefore, we have compiled this article, which addresses all the aspects of these similar, yet distinct strategies – risk, reward, and suitability.
Covered Call Writing
This widely popular strategy is usually not as easy to implement as one might at first believe. The strategy is simple enough in its design: buy a quantity of underlying, optionable stock and sell an equal (or lesser) number of options against it. As a result, there is limited upside profit potential (since the call was sold). Moreover, there is large downside risk, since the call premium generally only covers a relatively small percentage of any potential decline in the price of the underlying stock. But the strategy makes money if the stock is relatively unchanged – and most stocks are relatively unchanged over short time periods.
The strategy does require monitoring – for potential downside risk as well as for possible early assignment (although that may be welcome in many cases, as it means the maximum return is being realized). In addition, there is expiration activity that is usually required as well: rolling written options out to later months, for example.
Between the analysis of new positions, proper allocation of one’s capital in a uniform manner, and monitoring of the existing positions, there is often more work to do than the average investor has time for – which is why we say that the strategy is not as easy to implement as one might initially think.
Leverage is available in a small way in covered call writes, as they may either be done in a cash account (zero leverage) or in a margin account. The leverage in a margin account is actually slightly more than the 2-to-1 leverage available in stocks (where the margin rate is a simple 50%). In a covered call write, one must advance 50% of the stock price or the call’s striking price, whichever is lower – and then the option premium is deducted. So, for example, if one were to buy 1000 shares of XYZ at 42 and Sell the Dec 45 calls for 2 points, his required initial investments would be as follows:
Cash Margin Stock requirement 42,000 21,000* Option sale –2,000 –2,000 Net Investment 40,000 19,000 *: 50% of minimum of 42 or 45 Leverage: 40 / 19 = 2.11-to-1
If one writes in-the-money calls, as we normally do in our managed accounts1, the leverage factor is going to be roughly the same – just a little higher than 2-to-1.
Expected Return
We normally select our covered writes by expected return. We have written many articles on the concept of expected return, but for completeness’ sake, let’s summarize: expected return is the average return that one would expect to make if this investment were to be placed millions of times. In other words, it’s based on statistics (volatility and probability), but in any one case a covered write can make as much as its maximum profit if called away, or could lose a great deal if the stock falls, say, three standard deviations. Expected return is very useful in comparing different strategies in that it evaluates them all the same – merely computing the probability of the stock being at a certain price and multiplying that by the profit or loss of the strategy at that stock price. The bottom line is that if one constantly invests in positions with high expected returns, he will make a superior return overall.
As a result, our standard of measurement for covered writes, naked puts, and credit spreads will be expected return.
In the above covered writing example, if we assume that the volatility of the stock is 40%, that there are 3 months remaining until option expiration, that there is no dividend, and that commissions are 3 cents per share, the annualized pertinent returns are:
Annualized Returns Cash Margin Expected Return 1% –6% Maximum Return 49% 94% Unchanged Return 19% 32%
This is quite eye-opening. On margin, if the stock were called away at 45, we’d make $4.91 per share (after margin interest charges). On an investment of $19.06 (including commissions), that’s 94% annualized. However, our expected return is negative! In other words, this stock is volatile enough that it can lose a lot of money too – and hence when one considers volatility and probability, this is not a good covered write. Note that an expected return analysis does not incorporate any outlook for the underlying stock, but rather assumes that the stock will trade in line with a lognormal probability distribution.
So, how does the use of expected return specifically apply to the strategies that we’re discussing? Our parameters for covered call writing – at least in the current environment – are for there to be at least a 12% expected return on cash or an 18% expected return on margin before we consider the write. In addition, we usually stick with the stocks that are in the S&P 500 Index ($SPX).
Let’s use this example (it is the Humana (HUM) covered write that was recommended as Position CW90 in the last issue):
Stock: 52.90 Aug 50 call: 4.00 Volatility: 35% Time to expiration: 3 weeks (0.058 years) Dividend: 0 Commissions: 3 cents per share
Using this data, we arrive at the following:
Cash Margin Expected return 17% 26% Investment $4896 $2396
So, this satisfies our criteria, although it is boosted considerably by the fact that the time to expiration is so short. We will continue this example for the remainder of this article.
Naked Put Selling
The sale of a naked put is equivalent to a covered call write, in that both have profit graphs with the same shape: limited upside profit potential and potentially large downside risk.
Once an acceptable covered write has been identified via expected return analysis, one can consider a naked sale of the put with the same terms as the call (same striking price and expiration date). This put sale will almost certainly have a positive expected return as well, but there will be more leverage involved.
The exchange minimum investment required for the sale of a naked equity put is 20% of the stock price, plus the put premium, less any out-of-the-money amount (if applicable). That formula is then subject to an overriding condition that the margin is a minimum of 10% of the stock price in all cases.
When we write naked puts, however, we do not recommend using exchange minimum margin, but rather prefer margining the position as if the stock had fallen to the striking price or even the breakeven point.
Returning to the HUM example, then:
Aug 50 put: 0.90
Margin: 20% x 50 (strike price) + 0.90 (put price)
= 10.90 x $100 [shares per option]
= $1090
Expected profit from selling this put: $25
Expected return, annualized: 40%
As might be expected, the naked put sale has a higher expected return because of the leverage involved, even though we are not using exchange minimum margin requirements.
Put Credit Spread
In this strategy, one sells the same put as he would in the naked put strategy, but then buys a farther out-of-themoney put. This purchased put serves two purposes: 1) it limits the risk in the trade and, 2) it usually lowers the margin requirement even further – thus producing more leverage in the trade. The article on page 5 expands on this strategy, for those not familiar with it.
The margin requirement for a credit spread is the risk: the difference in the strikes, less the credit received for initially selling the spread. This margin requirement is fixed, and does not fluctuate even though the stock might trade up or down substantially in price.
Let’s continue the example of the HUM options. Suppose the following two HUM out-of-the-money puts are offered at the indicated prices, and we are considering buying one of them and sell the Aug 50 put at 0.90:
HUM Aug 45 put: 0.20 HUM Aug 40 put: 0.10
The expected profit on the purchase of either of these options is virtually a total loss.
......Credit Spreads......
Aug 45-50 Aug 40-50
Credit Received 0.70 0.80
Margin Required $430 $920
Expected Profit $5.50 $15
Annualized Exp Return 22% 28%
So, in this example, we can summarize as follows:
Strategy Exp Return Investment
Covered call, cash 17% $4896
Covered call, margin 26% $2396
Naked put 40% $1090
45-50 credit spread 22% $430
40-50 credit spread 28% $920
Hence, in this example – but most certainly not in all
situations – the naked put stands out, at 40%.
Position Size; Money Management
One of the most important elements in any investing philosophy is money management. For example, no matter how good an option purchase appears, one would not put his entire net worth into it, for he could lose everything in one position. Each different strategy may dictate a slightly different approach to money management.
In a covered call writing account – where only a fraction of the investment is at risk (from a practical standpoint), one would generally try to diversify by placing between 5% and 10% of his buying power in each covered write.
As for naked put writing, there are many philosophies that might apply, but they should generally be dictated by the amount of leverage one is willing to accept. Personally, I prefer to limit the naked put leverage to about 3 times the cash quantity. So, if one would have established a 500 share cash covered write, then 15 naked puts could be sold instead.
Note that if one merely used the allocated investment as a guide, the ratio would be 4.49:1 ($4,896 for the cash write divided by the $1,090 allocation for the naked put). That calculation usually yields a level of leverage that I personally find uncomfortably high.
Leverage is even higher for the put credit spreads. With the dollars that one could allocate to a cash covered write, one could do perhaps 10 times as many put spreads (in the above example, $4896 divided by $430 is a ratio of 11.4 to 1). That’s just too high. A plunge by the underlying stock could cause the put spread to lose nearly its maximum value, and that would be a hard loss to overcome. Realistically, one would probably want to limit the leverage factor to 5 or 6 times the cash quantity, at most.
Perhaps a better approach would be to risk a fixed percentage of the account on each trade, or at least divide that fixed percentage (3% to 5%) by the required margin for the approach you decide to take. Even so, one must be mindful of the leverage inherent in the put credit spreads, if that strategy is chosen.
Risk
As a practical matter, one should use mental stops on any of these strategies. That is, if the stock falls below the breakeven price (which is roughly the same for all the strategies), then one should consider closing the trade and moving to the sidelines or moving into another stock. This action not only keeps losses from reaching large levels – very important where leverage is involved – but allows one a better chance to recover from losses when they do occur.
Another way to limit risk is to cover any short options that can be repurchased for a minimal price, when available. That would mean that short puts (even in credit spreads) would be covered at a nickel – or maybe a dime if there is a considerable amount of time remaining until expiration. This also means that one should consider removing a covered call write if the short call can be bought back with a time value premium expenditure of only a nickel or dime. However, it is much more difficult to buy back deeply in-the-money calls than it is to buy back out-of-the-money puts. That fact gives the put strategies another advantage over the normal covered call write.
Summary
Strategically, all three of these approaches are variations on put selling. I’m sure many covered call writers don’t view it that way, but that’s what it equivalently is. The difference between them is mostly leverage, although there are some other advantages: lower commissions for naked put sellers, maximum defined risk for put credit spreads, and so forth.
IRA accounts would probably want to use cash covered writes (unless cash-based put selling is allowed – where the writer advances 100% of the striking price as margin for the naked put). In taxable accounts, covered writing is really not on a par with the other strategies – if less leverage is desired, one can always allocate more to the other strategies than the minimum margin required. One should use expected return calculations to determine whether the naked put or the put credit spread is more favorable on individual positions.
Frankly, it appears that covered call writing on margin is generally the inferior strategy. The leverage it provides can easily be attained with naked put selling or put credit spreads.
These mechanical considerations regarding investment size and leverage do not remove the obligation that one has to analyze the chart of the proposed underlying stock and to check news to see if there is a reason why a volatile move might occur (earnings, for example).
We will continue to recommend the alternative strategy – either a naked put sale or a put credit spread – along with our covered call writing recommendations. Note the change in format on page 4 for covered writes: the first line now lists the P&L of the covered write, while the second line shows the alternative strategy and its result.
This article was originally published in The Option Strategist Newsletter Volume 15, No. 15 on August 10, 2006.
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