Educational Strategy Reprints

Capital Efficient Covered Call Alternatives

Covered call writing has been very good to the Value Line Daily Options Survey over the past 4 ¾ years. Since the end of September 2001, our rank 1 covered calls have scored an average annual gain of 21.0%, versus only about a 7.5% dividend-adjusted annual gain for the S&P 500. However, there is one drawback to covered call writing for many option investors. Namely, covered calls require a relatively heavy outlay of capital. While you need only about $8,000 to $15,000 to create a diversified portfolio of call and put purchases, you would need about $35,000 for a portfolio of covered calls.

To remedy this problem, we explore alternative strategies to covered call writing that require less capital. These strategies include: (1) the writing "cash-covered" puts, (2) the writing of margined puts (2) bull call spreads, (3) bull put spreads and (3) long diagonal spreads. Option spreads, for instance, require only about one-third as much capital as do their comparable covered calls.

Cash Covered Put Writes

With a "cash-covered" put, you write the put and keep interest-bearing cash in your account equivalent to the exercise value of the put minus the premium you have taken. In an earlier report this year ("Cash-Covered Put Writes versus Covered Calls," Ot060501.pdf), we demonstrated how writing a covered call and a cash-covered put with the same stock, strike and expiration are virtually equivalent positions.

In Figure 1, we compare a covered call and a cash-covered put on Titanium Metals with the stock at $31.10, the August $30 call bid at $3.80 and the August $30 put bid at $2.65. What Figure 1 shows is that, once you factor in interest on the money you keep by not buying the stock, the returns on the two strategies turn out to be nearly identical. If the stock ends up at $30 or above, the covered call returns $270. On its own, the short put returns slightly less - $265; however, when you include the $13 interest on the cash portion of your cash-covered put, the return in this example is slightly greater - $278.

Although the "cash-covered" put nominally requires the same amount of capital as a covered call, it can be a more capital efficient strategy. This is because you do not necessarily need to post cash to establish the position. Provided your broker will let you, you can use other stock (usually at a 2 to 1 ratio to cash), bonds or mutual funds (also at a ratio and usually held 30 days or more) instead of cash. Thus, it is possible to establish "cash-covered" puts with no cash outlay. Another attraction to the cash covered put is the fact that if the stock ends up where you want to (at- or above the strike price), you do not need to close out any positions at expiration. You simply let the put expire worthless.

Writing Puts with Exchange Minimum Margins

You can also write puts by posting a margin. In our service, we call this "naked" put writing. The total margin on a "naked" write consists of the premium, which you must leave in your account, plus the greater of: 20% of the underlying amount minus the amount the put is out-of-the-money; or, 10% of the underlying. (We calculate and display this percentage for all options in our service.)

Obviously, when you write puts on margin, your position is much more highly leveraged than with covered calls or cash-covered puts. According to our performance numbers, "naked" put writing has done very well, with a gain of over 80% (based on return of funds posted for margin) over the past 4 ¾ years. However, we urge investors to pursue this strategy with some caution, since a major pullback in your stocks could generate losses well in excess of your original margins. One possible solution to this problem is to buy index puts to cover at least part of your risk.

A Bull Call Spread

Another very viable covered call alternative is the use of an option spread instead of the covered call. Let us start with the simplest example. Instead of buying the Titanium Metals stock and writing the August $30 covered call against it, we could still write the $30 call and buy an in-the-money call, a substitute for the stock.

In Figure 2, we show an example of such a spread. Here we have bought the August $22.50 call at $9.10 as a substitute for the stock. The total cost for establishing this spread is $530 ($910 for the long call minus $380 for the short call). This, of course, is less than one quarter of the $2,730 required for the covered call ($3,110 to buy the 100 shares of Titanium minus $380 for the $30 call). Notice in Figure 2 that the maximum profit on the bull call spread is $220 versus $270 for the covered call. This is because the $22.50 call has $50 worth of time premium. However, you have to remember that with the bull call spread, you have some insurance. Notice that if the stock drops by 50% to $15.55, you only lose $530 with the bull call spread, while with the covered call, your lose $1,175.

A Bull Put Spread

You can also use a bull put spread as a covered call substitute. In Figure 3, we show an example of a credit put spread in which we wrote the August $30 put on Titanium at $2.65 and bought the $22.50 put for $0.50 as a hedge against this short put. This spread is established at a credit of $215 ($265 - $50); however, the Exchanges require you to post a margin that is equal to the maximum amount you can lose. This margin works out to be the difference between the two strike prices times the number of underlying shares ($30 - $22.50 times 100 or $750) minus the $215 premium you have taken in. One nice feature of the bull put spread from a capital usage point of view is that most brokerages will allow you to use assets other than cash (usually in a greater than 1 to 1 ratio) for margin. Also, as with the cash-covered put, if the stock ends up above the strike price of the short put, you don't need to close out the position.

The Long Diagonal Spread

Rather than buy a lower-strike call with the same expiration as the one you have written, you can buy a longer-date call (also with a lower strike) as a substitute for the stock. We call this combination a long-diagonal spread. In Graph 1, we show an example in which we have bought the $20 December call for $13.00 as a substitute for the stock and have written a $30 call for $3.80. One nice feature of this type of position is that at the August expiration you can roll your short call just as you would with a regular covered call. Note: diagonal spreads can be tricky; therefore, we urge subscribers to test them out with our position evaluation software, Whatifi3.Xls.

Prepared by Lawrence D. Cavanagh,
Editor, Value Line Options
vloptions@valueline.com