A Covered Call Strategy
A covered call is an income-creating strategy where an investor sells or writes call options against shares of stock owned by the investor.
Normally, the investor would sell one contract for each 100 shares of stock. In exchange for selling the call options, the investor could gather an option premium. However, such a premium comes with an obligation.
In other words, a covered call is an options strategy that includes buying shares of stock and concurrently writing a call against that stock.
As far as a covered call strategy is concerned, an investor forsakes probable upside in place of upfront income in the manner of an option premium.
The option premium also delivers a modest amount of downside safeguard. The interest of investors in covered calls has been stimulated by a history of attractive risk-adjusted returns.
Because of the traditional nature of covered call writing, which decreases the downside risk instead of holding an underlying equity; the strategy is allowed in Individual Retirement Accounts ("IRAs").
But, an investor seeking to increase income and manage risk exclusively through covered calls is not understanding the complete picture; a normal covered call strategy could be improved by combining it with a cash-secured put strategy.
Link Between Cash Secured Puts & Covered Calls
Before concluding on the benefits of both strategies, it’s vital to comprehend the link between cash-secured puts and covered calls.
A cash-secured put strategy consists of selling a put and holding cash in suspension for the put obligation (or else the strategy would include leverage as the investor will require securing cash in case of an assignment).
Similar to writing a call, the sale of a put creates an upfront option premium. In other words, the profit payoffs of a covered call are equal to a cash-secured put. Since the two strategies have similar risk-return attributes, if they are not priced correspondingly an arbitrage opportunity occurs.
Therefore, by accepting that the two strategies are similar theoretically, a rational conversation of the gains of combining cash-secured puts with a conventional covered call strategy follows.
Securing Liquidity
A critical benefit of using the covered call as well as the cash-secured strategies is the capability to secure all obtainable liquidity, which decreases transaction costs.
Market experts accumulated trading information on the 10 biggest stocks in the S&P500 by market capitalization and using open interest as an alternate for liquidity, studied how the option liquidity was divided across an expiration cycle (over a two-month duration).
Option liquidity is naturally available around the at-the-money strike. The relative call and put slopes are usually very steep near the at-the-money strike. Again, as the calls and puts are deeper in the money, their slopes quickly begin to approach zero.
Considering the normal negative relationship between liquidity and trading costs were expanded, liquidity results in decreased transaction costs, an investor looking for a specific risk profile must select the most liquid of the corresponding covered call and cash-secured put.
Decreasing Transaction Costs
Commission costs and assignment charges can be reduced by using both covered calls and cash-secured puts.
For a seller of American-style options, assignments could occur, possibly at any given time until expiration, but usually, assignments only occur before the expiration when a stock goes ex-dividend or when an option is deep-in-the-money and time premium is almost zero.
If a stock provides a dividend, which more than 80% of the S&P 500 presently do, a covered call writer must face the risk of assignment when a stock is becoming ex-dividend and the dividend quantity is more than the quantity of time premium available in an in-the-money option.
Similarly, a deep in-the-money option contains the risk of initial assignment if there is meagre to no time premium available in the option.
Additionally, the brokerage fees paid because of an assignment are usually more than a commission for a normal option trade.
Hence, from a liquidity perspective, an investor seeking an in-the-money covered call on a dividend- paying stock can avert the risk of being called early, avoid costly assignment charges, and regularly take benefit of improved liquidity by instead writing an out-of-the-money put.
Covered call strategies have secured investors' consideration by generating attractive risk-adjusted returns.
But, an investor who depends on exclusively covered calls is neither reducing costs nor taking advantage of accessible liquidity.
By considering the connected influence of liquidity and trading costs, a critical inference is arrived at - combining cash-secured puts to a covered call strategy significantly increases the available percentage of the risk spectrum.
From the outlook of a covered call strategy's downside risk, the more in-the-money a call is written, the less risk it has. This is because of a greater buffer before participating in the downside.
In-the-money calls are usually less liquid and exposed to initial assignment, but an out-of-the-money cash-secured put is not.
More commonly, it pursues that with the capability to use either covered calls or cash secured puts, an investor can more accurately execute an investment theory by selecting the most effective strategy at a given strike price.
Hence, a covered call strategy could be improved - augmented liquidity, reduced costs, and improved optionality - by integrating it with a cash-secured put strategy.
Normally, the investor would sell one contract for each 100 shares of stock. In exchange for selling the call options, the investor could gather an option premium. However, such a premium comes with an obligation.
In other words, a covered call is an options strategy that includes buying shares of stock and concurrently writing a call against that stock.
As far as a covered call strategy is concerned, an investor forsakes probable upside in place of upfront income in the manner of an option premium.
The option premium also delivers a modest amount of downside safeguard. The interest of investors in covered calls has been stimulated by a history of attractive risk-adjusted returns.
Because of the traditional nature of covered call writing, which decreases the downside risk instead of holding an underlying equity; the strategy is allowed in Individual Retirement Accounts ("IRAs").
But, an investor seeking to increase income and manage risk exclusively through covered calls is not understanding the complete picture; a normal covered call strategy could be improved by combining it with a cash-secured put strategy.
Link Between Cash Secured Puts & Covered Calls
Before concluding on the benefits of both strategies, it’s vital to comprehend the link between cash-secured puts and covered calls.
A cash-secured put strategy consists of selling a put and holding cash in suspension for the put obligation (or else the strategy would include leverage as the investor will require securing cash in case of an assignment).
Similar to writing a call, the sale of a put creates an upfront option premium. In other words, the profit payoffs of a covered call are equal to a cash-secured put. Since the two strategies have similar risk-return attributes, if they are not priced correspondingly an arbitrage opportunity occurs.
Therefore, by accepting that the two strategies are similar theoretically, a rational conversation of the gains of combining cash-secured puts with a conventional covered call strategy follows.
Securing Liquidity
A critical benefit of using the covered call as well as the cash-secured strategies is the capability to secure all obtainable liquidity, which decreases transaction costs.
Market experts accumulated trading information on the 10 biggest stocks in the S&P500 by market capitalization and using open interest as an alternate for liquidity, studied how the option liquidity was divided across an expiration cycle (over a two-month duration).
Option liquidity is naturally available around the at-the-money strike. The relative call and put slopes are usually very steep near the at-the-money strike. Again, as the calls and puts are deeper in the money, their slopes quickly begin to approach zero.
Considering the normal negative relationship between liquidity and trading costs were expanded, liquidity results in decreased transaction costs, an investor looking for a specific risk profile must select the most liquid of the corresponding covered call and cash-secured put.
Decreasing Transaction Costs
Commission costs and assignment charges can be reduced by using both covered calls and cash-secured puts.
For a seller of American-style options, assignments could occur, possibly at any given time until expiration, but usually, assignments only occur before the expiration when a stock goes ex-dividend or when an option is deep-in-the-money and time premium is almost zero.
If a stock provides a dividend, which more than 80% of the S&P 500 presently do, a covered call writer must face the risk of assignment when a stock is becoming ex-dividend and the dividend quantity is more than the quantity of time premium available in an in-the-money option.
Similarly, a deep in-the-money option contains the risk of initial assignment if there is meagre to no time premium available in the option.
Additionally, the brokerage fees paid because of an assignment are usually more than a commission for a normal option trade.
Hence, from a liquidity perspective, an investor seeking an in-the-money covered call on a dividend- paying stock can avert the risk of being called early, avoid costly assignment charges, and regularly take benefit of improved liquidity by instead writing an out-of-the-money put.
Covered call strategies have secured investors' consideration by generating attractive risk-adjusted returns.
But, an investor who depends on exclusively covered calls is neither reducing costs nor taking advantage of accessible liquidity.
By considering the connected influence of liquidity and trading costs, a critical inference is arrived at - combining cash-secured puts to a covered call strategy significantly increases the available percentage of the risk spectrum.
From the outlook of a covered call strategy's downside risk, the more in-the-money a call is written, the less risk it has. This is because of a greater buffer before participating in the downside.
In-the-money calls are usually less liquid and exposed to initial assignment, but an out-of-the-money cash-secured put is not.
More commonly, it pursues that with the capability to use either covered calls or cash secured puts, an investor can more accurately execute an investment theory by selecting the most effective strategy at a given strike price.
Hence, a covered call strategy could be improved - augmented liquidity, reduced costs, and improved optionality - by integrating it with a cash-secured put strategy.
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