Investing can be a great way to grow your wealth, but it can also be a daunting task if you’re new to the game. Here on YMIDoingThis we look to find great ideas and ways to help you achieve your financial goals. Two popular option strategies for generating income to achieve financial success are from using stocks to sell cash secured puts and covered calls. Both involve selling options on stocks you own, but they differ in some important ways. In this post, we’ll explore the differences between these two strategies, the pros and cons of each, and how to decide which is right for you.

Explanation of a Cash Secured Put vs Covered call

Let’s start with cash secured puts. This strategy involves selling a put option on a stock you would be willing to buy at a lower price. The put option gives the buyer the right to sell you the stock at a certain price (the strike price) within a certain time frame. In exchange for selling the put option, you receive a premium, which is money paid upfront by the buyer. If the stock price falls below the strike price, you will be obligated to buy the stock at the strike price, but you will have received the premium as a cushion.

Covered calls, on the other hand, involve selling a call option when you already own the underlying stock. The call option gives the buyer the right to buy the stock from you at a certain price (the strike price) within a certain time frame. In exchange for selling the call option, you receive a premium, which is money paid upfront by the buyer. If the stock price rises above the strike price, the buyer will likely exercise the option and buy the stock from you at a profit, but you will have received the premium as income.

Examples of Cash Secured Puts vs Covered Calls

Cash-secured put example:

Keeping in line with the prior section we’ll start with a cash-secured put.  Before getting started it should be noted that this is not a recommendation to buy or sell any securities, but just an example of how they work.  We’ll use Coinbase as the underlying stock, ticker COIN, for this example option trading strategy to sell covered puts.  With this strategy the investor sells a put on COIN with the goal to collect the option premium.

To get started, the current market value of COIN is $60.50 today. When selling the put remember the premium you collect is per share and each contract represents a lot of 100 shares.  You are also choosing an expiration date, or the date when the contract terminates. 

Here’s a screenshot of what the current market is for put options that expire on May 19, 2023 which is 29 days until it expires. 

The May 19 date is the standard monthly expiration date, which is the third Friday of each month.  To use this put strategy we would sell an option contract below the current market price and collect the premium.  To establish this short put position we’d need to have enough cash in the broker account to buy the underlying stock in the event the option expires in the money.  This means the price of the stock is lower than the strike price we selected and we’ll have to buy 100 shares of the underlying stock, in this case COIN. 

For this example let’s say we are comfortable purchasing the stock for $55.  So for this example we need to have $5,500 in the account to place the trade on one contract.  When we sell a put we’d collect a premium of $2.93 per share.  Each contract represents 100 shares so the total we’d receive in the account of the day of the trade is $293.00.  Basically we are tying up that $5,500 for a month and in exchange we will collect the premium.  The return if the option expires worthless is 5.3% for the month.

The potential profit in this trade is the premium received if the option expires worthless.  The risk associated with selling  cash-secured puts is that when buyers exercise their option, we have to buy the COIN shares at the strike price while the price of the underlying stock could continue to go down.  For example if we had sold an option the Monday morning after the March expiration (third Friday) COIN was at 76.76.  If we had followed the same discount more or less, somewhere around $70 per share, we’d be getting assigned tomorrow, as the stock is well below that strike price.   

In summary for the example of selling a cash-secured put, we need $5,500 in the account.  We sell the May 19, 2023 put option with a $55 strike price for a premium of $2.93 which will expire in 29 days.  So for holding those funds in the account for 29 days we’ll collect a 5.3% return if the put expires worthless.  This is something that can be repeated on an annual, quarterly, monthly, or even weekly basis.  Keep in mind with volatile stocks you won’t receive the same premium each month.  It will vary, and there is also the risk of having the stock assigned. In other words you might have to buy it at that strike price. 

Covered call example:

We’ll use the same stock, COIN for the covered call writing example.   Again, the current price is at $60.50, and the difference with the strategy of selling covered calls vs cash-secured puts, is we would already own 100 shares of the COIN stock position.  For this example we’d choose a strike price that we are willing to sell the stock for.  

Here’s a picture of the current call options over $60.00.

Keeping in mind this is just an example, so for selling calls let’s choose a strike price a little farther out, say $70, which would be over a 10% increase in a month.  If we used the same expiration date, May 19, 2023 the premium collected for writing a covered call would be $3.45.  Just like when your sell a cash secured put, when you write covered calls you are writing a contract for 100 shares.   So when the option is sold we’d collect $345.00 in the account and have to hold the stock during the period as before. 

Calculating the return of the covered call position if it expires worthless is a little different.  When doing this I’d use the price of the stock, which is basically the amount of money invested a the time of writing an option.  For this example we’d using the price we started with COIN at or $60.50, or $6,050 for 100 shares.  We are collecting $345.00 so this calculates to a 5.7% return during that 29 day period.  Like how the puts work, covered options can be sold annually, quarterly, monthly and on some stocks weekly. 

The potential profit in this type of trade is the premium that you collect for selling the option.  The risk is that the stock increases in value higher than your strike price, which means you’d have to sell the stock, meanwhile the stock could continue increasing in price.  You’d miss out on the increased value of the stock.

Pros and Cons of Cash Secured Puts and Covered Calls

One advantage of cash secured puts is that they allow you to buy stocks at a discount. If the stock price falls below the strike price, you will be able to acquire the stock at a lower price than it was trading for when you sold the put option. Additionally, selling put options can be a good way to generate income in a sideways or slightly declining market. However, the downside is that you may be obligated to buy the stock at the strike price, which could result in a loss if the stock continues to decline in value.

Covered calls, on the other hand, can be a good way to generate income from stocks you already own.  There are some investors who compare selling a covered call to creating an extra dividend. The premium you receive for selling the call option can help offset any declines in the stock’s value, and if the stock price remains below the strike price, you get to keep the premium as income. However, the downside is that if the stock price rises above the strike price, you may be forced to sell the stock at a lower price than it’s currently trading for, which means you miss out on any further gains.

Risks of Cash Secured Puts

Stock price risk: If the stock price falls below the strike price of the put option, you may be obligated to buy the stock at the strike price, which could result in a loss if the stock continues to decline in value.

Market risk: The stock market as a whole can be volatile, and a sharp decline could cause the value of your put option to decrease, reducing your potential profit or increasing your potential loss.

Assignment risk: If the stock price falls below the strike price of the put option and the buyer decides to exercise the option, you will be obligated to buy the stock at the strike price, even if it has declined significantly in value.

Time decay risk: As the expiration date of the put option approaches, its value will decline, which means you may need to sell additional put options to maintain your income stream.

Interest rate risk: Interest rates can impact the value of options, so changes in interest rates can affect the profitability of your strategy.

Liquidity risk: If the stock you are selling put options on is not very liquid, it may be difficult to find a buyer for the option, which could make it harder to exit the position if needed.

Risks of Covered Calls

Opportunity cost risk: By selling a covered call, you give up the potential for additional gains if the stock price rises above the strike price of the call option. If the stock continues to rise, you may miss out on significant gains.

Assignment risk: If the stock price rises above the strike price of the call option, the buyer may exercise the option, and you will be obligated to sell the stock at the strike price, even if it has risen significantly in value.

Stock price risk: If the stock price falls below the strike price of the call option, you may still receive the premium, but the value of the stock itself may have declined significantly.

Market risk: The stock market as a whole can be volatile, and a sharp decline could cause the value of your covered call to decrease, reducing your potential profit or increasing your potential loss.

Time decay risk: As the expiration date of the call option approaches, its value will decline, which means you may need to sell additional call options to maintain your income stream.

Liquidity risk: If the stock you are selling call options on is not very liquid, it may be difficult to find a buyer for the option, which could make it harder to exit the position if needed.

It’s important to carefully consider these risks before deciding to sell covered calls and to have a solid understanding of the strategy and the market before getting started. It’s also a good idea to consult with a financial advisor or professional before making any investment decisions.

In conclusion, both covered calls and cash secured puts can be effective strategies for generating income from stocks, but they come with their own set of pros and cons. Cash secured puts can allow you to buy stocks at a discount and generate income in a sideways or slightly declining market, but they also carry the risk of being obligated to purchase the stock at a loss. Covered calls can generate income from stocks you already own and help offset any declines in the stock’s value, but they may force you to sell the stock at a lower price if it rises above the strike price. Ultimately, the decision to use one strategy over the other will depend on your individual investing goals and risk tolerance.