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If you write a put on a stock and keep enough cash in your account to cover your maximum risk, you create a position known a “cash-covered put write.” There is no margin requirement on the cash-covered put and the position’s gain and loss profile is almost identical to the corresponding covered call (same stock, strike, and expiration). In this week’s report, using put and call examples from Bio-Rad Labs (BIO), we show you how these two strategies are basically equivalent.  We also discuss when cash-covered puts might be preferable to covered calls.

Two Equivalent Positions
A covered call consists of the stock and a written call.  A cash-covered put consists of a written put and cash in the account equal to the strike price value minus the premium received. With a covered call, you can never lose more than the original cost of the position (stock minus premium times the number of shares).  With a cash-covered put, you can never lose more than the original amount of cash you post (strike minus premium times the number of shares). Neither position requires any margin.

Take a look at Figure 1 below. Here we compare the outcomes of (1) a covered call - buying 100 shares of Bio-Rad Labs common stock at $102.19 and writing one June 2010 $100 call at $6.00 (total cost $96.19 per share or $9,619 on one covered call) and (2) a cash-covered put - writing one June 2010 $100 put at $3.70 (again with the stock at $102.19). If the put is fully covered by the difference between the strike price amount and the premium (in this case $96.30 per share or $9,630 on one put), the outcomes of the two strategies are the same.  With the covered call, if stock ends up at $100 or above, gains and losses on the tangible value of short call and the stock will offset each other and the investor will keep the original time premium plus any dividend (assuming that the call had not been exercised before expiration).

With the cash-covered put write, as long as the stock ends up above the $100 strike price, investors get to keep the entire put premium of $3.70 or $370 on the transaction.  In addition, investors collect interest on the cash used to cover the position.  In our example, this works out to be $11 for the 87 days from the 3/24/2010 trade date to the 6/19/2010 expiration.

Doing the Math
In Figure 2, we compare how you calculate the annualized return, the breakeven percentage and the maximum profit on a covered call and a cash-covered put.  Notice that the cash-covered put can require a larger outlay of funds, but this difference is made up by the interest earned on these funds.   Notice also that with the covered call, we often need to add dividends to the return, breakeven and maximum profit calculations, while with the cash-covered put, we have to add the interest income to these same calculations.  We are making these calculations available in a template, CCPut.Xls, which is available on request at vloptions@valueline.com.

Which Strategy is Best?
Looking again at our Figure 1 and Figure 2 examples, notice that the cash-covered put and the covered call offer basically the same rewards and risk.  This is not always the case, however. Sometimes one strategy will offer better returns and breakeven percentages than the other.  
In our example, one might say that the cash-covered put is preferable.  Why? Because if the stock ends up above the $100 strike price, the cash-covered put requires no close-out transaction – and no further commissions.  The covered call, by way of contrast, will require that investors either buy back the call and sell the stock or allow the stock be called away.  (All these transactions entail commissions.)
In addition, with the covered call, you have to worry about the possibility that the in-the-money call will be exercised before expiration.  Usually, this only happens when the stock has an ex-dividend date shortly before expiration.  The ex-dividend date is the day on which the company identifies the owner of the stock.  Thus, the holder of a long call that is in-the-money might want to exercise the call (i.e. buy the stock) before expiration.

Simple rules of thumb are:  If the stock is above the strike price, then it makes more sense to write the cash-covered put.  If the stock is below the strike price, then the covered call makes more sense.

Cash-Covered Puts in Our Service
With all the options in our service, we show the per-annum returns, the downside protection and the maximum profit potential for either the call or the put, depending on which it is.  These numbers are displayed in Options by Stock Ticker, in My Portfolio and in our detailed Options Profile.  You can also use these numbers as search criteria in our Options Screener, finding those cash-covered puts or covered calls that best suit your needs.

Cash-Covered Puts: Doing the Math - Figure 1 Bio-Rad Labs

 

Cash-Covered Puts: Doing the Math - Figure 2 Risk/Reward Calculations of Bio Rad Labs