Covered Calls and Cash-Secured Puts

Covered calls and cash-secured puts are foundational income strategies that involve selling options against held assets. Both strategies generate premium income while accepting defined obligations, making them appropriate for investors seeking yield enhancement with understood risk parameters.

Definition and Key Concepts

Covered Calls

A covered call involves owning the underlying stock and selling a call option against those shares. The call writer:

• Collects premium income immediately
• Agrees to sell shares at the strike price if assigned
• Retains stock dividends and limited upside

The position is "covered" because the writer owns shares to deliver if the call is exercised.

Cash-Secured Puts

A cash-secured put involves selling a put option while holding cash sufficient to purchase shares if assigned. The put writer:

• Collects premium income immediately
• Agrees to buy shares at the strike price if assigned
• Earns interest on the cash reserve

The position is "secured" by cash available to fulfill the purchase obligation.

Strategy Comparison

How It Works in Practice

Covered Call Mechanics

Position Setup:

1. Own 100 shares of XYZ at $50 (cost: $5,000)
2. Sell 1 XYZ $55 call for $1.50 premium (receive: $150)

Greeks Profile (Short Call Leg):

• Delta: -0.30 (reduces net position delta from 1.00 to 0.70)
• Theta: +$0.04 per day (earns time decay)

Possible Outcomes at Expiration:

Maximum gain: ($55 - $50) + $1.50 = $6.50 per share ($650 per contract) Breakeven: $50 - $1.50 = $48.50

Cash-Secured Put Mechanics

Position Setup:

1. Hold $5,000 cash (to buy 100 shares at $50)
2. Sell 1 XYZ $50 put for $2.00 premium (receive: $200)

Greeks Profile (Short Put Leg):

• Delta: +0.45 (positive delta from short put)
• Theta: +$0.05 per day (earns time decay)

Possible Outcomes at Expiration:

If assigned at $50: Effective cost = $50 - $2.00 = $48.00 per share Breakeven: $50 - $2.00 = $48.00

Worked Example

Covered Call Case Study

You own 200 shares of ABC at $75, purchased for $15,000. You want to generate income while holding.

Trade:

• Sell 2 ABC $80 calls, 30 days to expiration
• Premium received: $2.00 per share ($400 total)
• Call delta: -0.28 per contract
• Theta: +$0.06 per contract per day

Analysis:

Outcome Scenarios:

1. ABC at $72 at expiration: Calls expire worthless. You keep $400 premium. Net value: $14,400 + $400 = $14,800. Loss cushioned by $2 premium.

2. ABC at $85 at expiration: Calls are assigned. You sell 200 shares at $80. Proceeds: $16,000 + $400 = $16,400. Missed $1,000 upside above $80.

3. ABC at $78 at expiration: Calls expire worthless. You keep shares worth $15,600 plus $400 premium = $16,000.

Cash-Secured Put Case Study

You want to buy DEF at $60 but think it's currently at $65, slightly overvalued.

Trade:

• Sell 1 DEF $60 put, 45 days to expiration
• Cash reserved: $6,000
• Premium received: $1.75 ($175)
• Put delta: +0.32
• Theta: +$0.03 per day

Outcome Scenarios:

1. DEF at $70 at expiration: Put expires worthless. Keep $175. Return on reserved cash: 2.9% for 45 days.

2. DEF at $55 at expiration: Assigned at $60. Buy 100 shares for $6,000. Effective cost: $58.25. Immediate paper loss of $325 but you wanted the stock at $60 anyway.

Risks, Limitations, and Tradeoffs

Capped Upside (Covered Calls)

Covered calls sacrifice unlimited upside for certain premium. If the stock rallies significantly, you miss gains above the strike. This opportunity cost can exceed the premium collected multiple times over in strong trends.

Assignment Obligation (Cash-Secured Puts)

Cash-secured put writers must purchase shares at the strike regardless of how far the stock falls. If a stock drops from $50 to $20, you still pay $50 per share—a loss of $30 minus the premium received.

Opportunity Cost

Cash reserved for puts earns minimal interest. The premium collected must exceed alternative uses of capital to be worthwhile. Similarly, capital tied up in covered call stock cannot be deployed elsewhere.

Dividend Considerations

For covered calls, deep ITM calls may be exercised early before ex-dividend dates. You might lose the stock and the dividend simultaneously. Monitor positions near ex-dates.

Common Pitfalls

1. Selling calls at strikes too close to current price: Limits upside significantly for modest premium.

2. Ignoring assignment timing: Short calls can be assigned anytime, especially near dividends.

3. Overleveraging cash-secured puts: Writing puts on more cash than you can afford ties up capital and creates forced buying.

4. Not having a plan for assignment: Know in advance whether you want the stock if put is assigned.

5. Selling calls on stocks you want to hold forever: Assignment creates taxable events and disrupts long-term positions.

Checklist for Income Strategies

• Confirm you're willing to sell shares at the strike price (covered calls)
• Verify you want to own the stock at the effective cost (cash-secured puts)
• Calculate breakeven and maximum gain before entering
• Check upcoming dividends and earnings dates
• Assess premium as a percentage of capital at risk
• Evaluate delta to understand directional exposure
• Monitor theta to track time decay benefits
• Set exit rules for rolling or closing before expiration

Next Steps

For downside protection strategies that complement covered calls, see Protective Puts and Collars. These strategies add hedging to long stock positions.