The Value Line Daily Options Survey

Capital Efficient Covered Call Alternatives

Covered call writing has been very good to the Value Line Daily Options Survey. Over the past six and a half years, our rank 1 covered calls have scored an average annual gain of 15.9% versus only about a 6.5% 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 of “cash-covered” puts, (2) the writing of margined puts, (3) bull call spreads, (4) bull put spreads and (5) 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. In a recent report (“Cash-Covered Puts: Doing the Math,” Ot071217.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 on page 3, we compare a covered call and a cash-covered put on Oracle with the stock at $20.46, the June $20 call bid at $0.90 and the June $20 put bid at $0.45. What Figure 1 shows is that once you factor in interest on the money you keep in the account to post the position, the returns on the two strategies turn out to be nearly identical. If the stock ends up at $20 or above, the covered call returns $99. On its own, the short put returns slightly less - $90; however, when you include the $10 interest on the cash portion of your cash-covered put, the return in this example is slightly greater – i.e. $100.

Although the “cash-covered” put nominally requires about 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. Note: this strategy can not be used in accounts (such as IRA accounts) which do not allow ordinary margins. Also note that if you use stock for margin, you are not getting any interest income. One final attraction of the cash-covered put is that if the stock ends up above the strike price, you do not need to closeout your position. 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 an annualized gain of over 40% (based on return of funds posted for margin) over the past six and a half 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 Oracle stock and writing the June $20 call against it, we could still write the $20 call and buy an inthe- money call, as a substitute for the stock.

In Figure 2 on page 3, we show an example of such a spread. Here we have bought the June $15.00 call at $5.70 as a substitute for the stock. The total cost for establishing this spread is $425 ($570 for the long call minus $145 for the short call). This cost, of course, is less than one quarter of the $1,901 required for the covered call ($2,046 to buy the 100 shares of Oracle minus $145 for the $20 call). Notice in Figure 2 that the maximum profit on the bull call spread is $75 versus $99 for the covered call. This is because the $15.00 call has $24 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 $10.23, you only lose $425 with the bull call spread, while with the covered call, your lose $878.

A Bull Put Spread

You can also use a bull put spread as a covered call substitute. In Figure 3 on page 4, we show an example of a credit put spread in which we wrote the June $20 put on Oracle at $0.90 and bought the $15.00 put for $0.10 as a hedge on this short put. This spread is established at a credit of $80 ($90 - $10); 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 ($20 - $15.00 times 100 or $500) minus the $90 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 any positions.

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 on page 4, we show an example in which we have bought the $10 January 2010 call for $11.30 as a substitute for the stock and have written the $21 June call for $0.90. One nice feature of this type of position is that at the June expiration you can roll your short call just as you would with a regular covered call and continue to use your long call as a substitute for the stock.

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
vloptions@valueline.com