Combine a Covered Call and a CSEP

Key Points

  • Selling cash secured equity puts (CSEPs) allows you to set a price you're willing to pay for a stock you want to own, while generating a small amount of income.
  • Covered calls can be an effective way to sell a position at your desired price, while generating a small amount of income.
  • Together, these strategies can help to generate income in an actively managed portfolio.

Options strategies can have a number of goals—such as protecting the value of an asset (hedging), generating income (from option sale proceeds), or specifying exit and entry prices. In this article, we'll focus on a strategy that emphasizes the latter two goals—buying and selling securities at prices you like, while generating income, but also providing a limited amount of hedging. To do this, we use covered calls and cash secured equity puts (CSEP) in an alternating fashion.

A covered call is a popular options strategy in which the investor owns a security and writes (or sells) call options on that same security. In essence, it allows you to specify the price where you'd like to sell a particular security while you generate income. It's almost like you are getting "paid" to enter a limit sell order.1

A CSEP involves writing (selling) a put option and setting aside enough cash in your account to buy the security if you are assigned. CSEPs are generally written out of the money (OOTM), meaning at a strike price that is below the underlying stock's current price. In other words, you are specifying the price where you'd like to buy this security plus generating income. It's almost like you are getting "paid" to enter a limit buy order.1

Why use these strategies together?

Take a look at the profit and loss profile of a CSEP and a covered call below. You'll notice that the profit and loss characteristics of these two strategies are quite similar. A key difference however, is that a CSEP generates income first but might ultimately result in a stock purchase; a covered call generates income after a stock is purchased but might ultimately result in a stock sale—so why not sell CSEPs to buy your stocks and then write covered calls to sell your stocks? If you have the time and desire to actively manage your account, this two-pronged approach can perform quite well under the right circumstances.

Profit and loss profile of a CSEP

Profit and loss profile of a CSEP

Source: Schwab Center for Financial Research.

Profit and loss profile of a covered call

Profit and loss profile of a covered call

Source: Schwab Center for Financial Research.

Investors considering this strategy should have a sizable cash balance in an account with at least level "1" option approval at Schwab, and be interested in building an equity portfolio.

Find candidates for this strategy

If you don't have specific stocks in mind, a good first step is to use the Stock Screener. This tool can be accessed on Schwab.com by selecting Research > Stocks > Screeners. Note that there are many criteria from which you can choose to create a screener. For the sake of simplicity, I will look at the following:

Basic criteria: After you access the Stock Screener, the first thing you'll want to do is specify some basic criteria for the universe of stocks you'd like to consider:

Basic Criteria

For purposes of this example, let's assume you set the following basic criteria:

  • Price: > $10 per share
  • Average volume (10 Day): > 1M shares per day
  • Optionable stocks: Yes

Analyst ratings: After you've defined the basic criteria, the next thing you may want to do is narrow your search to only stocks that are highly rated by the various ratings services Schwab provides:

Analyst Ratings

For purposes of this example, let's assume you set the following basic criteria:

  • Schwab Equity Rating = A and B
  • Schwab Industry Rating = A, B and C
  • Standard & Poor's Star Rating = 3, 4 and 5

Company performance: After you've defined the analysts' ratings, the next thing you may want to do is narrow your search to only stocks that demonstrate the fundamental criteria you find important:

Company Performance

For purposes of this example, let's assume you set the following fundamental criteria:

  • Revenue growth rate last five years: > 15%
  • EPS growth history last three years: > 15%

Using the above criteria, you'll probably find 30 to 50 potential candidates. If you want to use your specific screener criteria again, enter a name and select the "Save Screen" button. Below is a partial excerpt of how your output screen will look.2 As an example, let's use the first 10 names on this list.

Screen Results

Source: Schwab.com as of March 26, 2013. All information is shown for illustrative purposes only, and is subject to change without notice.

Check the chart

If technical analysis is a part of your regular trading strategy, be sure to check the chart before you trade. Remember, you are hoping to buy these stocks at prices you consider favorable and viewing a chart may help you identify technical support levels that you consider good entry prices.

I have selected CVX as an example from the list above. Note that CVX was selected for illustrative purposes only and I'm not making a recommendation of this security. Also, note that ratings, prices, and other information is dated.

In the one-year chart below, it appears that CVX has experienced some resistance (red arrows) and some support (green arrows) at approximately $110. You may interpret the chart differently, but I'll use $110 for this illustration.

Check the chart

Source: StreetSmart Edge®.

CSEP order entry

Should you decide that you are comfortable buying CVX around $110, you could either:

  • Enter a limit order to buy 200 shares at $110,
  • Or sell two put options with a 110 strike price expiring in 65 days at the current bid price of $1.15. This would bring in a cash credit of $230 before commissions.

CSEP assignment

If CVX is below $110 at (or before) expiration, you will be assigned and purchase 200 shares of CVX at $110. If you apply the $230 credit you already received, your effective cost basis would be $108.85 before commissions, which also means that CVX would have to drop below $108.85 before you would incur a loss. At its current price of $115.93, that equates to a decline of more than 6% in about two months. If you are assigned and your goal was to acquire CVX at a price that you considered fair, you would basically be done at this point.

If CVX is above 110 at expiration, your put options will expire and the maximum profit you would earn is $230 less commissions. In other words, you could miss out on a much larger profit opportunity if the stock rises sharply.

Of course, if CVX drops way below $108.85, your losses could be substantial, and you may find yourself in a position where you have no covered call strike prices (discussed below) available that will result in a profit if assigned. The net loss on your stock position will have wiped out your short-term income and then some. Since it is not a good idea to sell a covered call at a strike price that will result in a loss if assigned, you may need to wait for some upside price movement before you can sell covered calls.

Covered call order entry

Let's assume that CVX drops to $109 by expiration and you are assigned. At this point, with a cost basis of $108.85, you may look at the chart again and decide that you would be happy to sell CVX if it reaches $115 again. Like before, you could simply enter a limit order to sell 200 shares at $115 or you could sell two covered call options with a 115 strike price expiring in 65 days at the current bid price of .95. Doing so would bring in a cash credit of $190 before commissions. At this point by applying the new covered call premiums to your original effective cost basis of $108.85, you would have a new effective cost basis of $107.90.

Covered call assignment

For purposes of this example, let's assume that CVX increases to $116 by expiration and you get assigned at $115 at (or before) expiration. With an effective cost basis of $107.90 on 200 shares, your overall profit would be $1,420 ([$115 – $107.90] x 200) before commissions. This equates to a profit of just over 6% in a little more than four months. Of course if CVX rises sharply above $115, your profit doesn't change, but you will have missed out on the opportunity for a potentially much larger profit. In other words, the covered call caps your selling price (and thus your profitability) at the strike price.

If CVX drops sharply after you sell your covered calls, your losses could be substantial. And while your first two covered calls will expire worthless, you may not be able to recover your losses with subsequent sales of covered calls, as there may be no covered call strike prices available that will result in a profit. Again you may need to wait for some upside price movement before you can sell additional covered calls.

CSEP expiration

If we step back for a moment to when you were still short the original 110 puts, if CVX had not dropped below 110 at expiration, the put options would have expired worthless and you could have kept the $230 credit with no further obligation. You then may or may not have chosen to sell more put options at the same or different strike price for a later expiration and start the process all over again.

While it's impossible to know ahead of time if you'll be assigned or not, viewing the Delta of the CVX 110 put options (-.23) tells you that at the moment you enter the trade, there is theoretically about a 23% chance of assignment at or before expiration. Of course Delta is a dynamic calculation, so as the stock price dropped, the odds of assignment also increased.

Covered call expiration

Likewise, if we assume you were assigned on the CSEPs, but we step back to when you were still short the 115 calls, it's possible that the calls might not be assigned. If CVX had not risen above $115 at expiration, the call options would have expired worthless and you would get to keep the $190 credit with no further obligation. You then might or might not have chosen to sell more call options at the same or different strike price for a later expiration and wait again to see if you get assigned. As with the puts, viewing the Delta of the CVX 115 call options (.21) would have told you that at the moment you entered the trade, there was theoretically about a 21% chance of assignment at or before expiration.

Repeat the process

Expanding upon this example, assume you went through a similar process and identified 10 of the 41 stocks in the screener list that you would like to own. If you then proceeded to sell 65-day OOTM (out-of-the-money) put options on the other nine stocks and they had a similar Delta you might expect to be assigned on maybe two or three of them each month, at expiration.

For those two or three on which you get assigned on the puts, you can sell covered calls if the prices haven't dropped too far. For the other seven or eight, if you still like them, you can decide to sell short puts again and wait to see if you get assigned. While the probabilities can change over time, since all OOTM puts will initially have less than a 50% chance of assignment it is very unlikely that you'll be assigned on all of them, unless the market drops substantially before expiration. Likewise, since the OOTM covered calls will also have less than a 50% chance of assignment, it is very unlikely that you'll be assigned on all of them, unless the market increased substantially.

What to keep in mind

If you follow a process similar to the one outlined above, at any point in time you'll likely have some equity positions in your account, some short puts outstanding, some covered calls outstanding, some puts expiring and some calls expiring. This type of situation requires careful attention to monitor properly, so be sure you have the time and risk tolerance this strategy requires. Using these strategies in this more complex manner requires a higher risk tolerance than might normally be required of an occasional option trader.

  • Because this strategy involves many option trades, commission charges could be substantial and are a much greater consideration that a buy and hold stock strategy. Be sure to factor commission charges into all profit and loss calculations.
  • Keep in mind that if this strategy is used on dividend paying stocks, you will not be entitled to any dividends unless you purchase the actual stock before the ex-dividend date. You also will not be entitled to voting rights or any other benefits of stock ownership unless you own the actual stock.
  • Both CSEPs and covered calls will prevent significant profit potential if the stock moves substantially higher.
  • While the income generated by these strategies does provide a small amount of downside risk protection, that protection is limited only to the option premiums.
  • If the price of the underlying stock drops substantially prior to the expiration date of the option, your losses could be significant.
  • Losses are reduced only by the amount of option premium you received on the initial sale of the option.
  • While the examples above assume that you hold the position until expiration, you can usually close out short options prior to expiration by buying them to close at the current market price.
  • Keep in mind that if your covered call or short put is in the money, you could be assigned at any time.

 

Next Steps

  • Schwab clients: Contact a Trading Specialist at 800-435-9050 for questions or log in to the Trading Services Learning Center.
  • Not yet a client? Learn more about Schwab Trading Services.

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