I assume you are all familiar with the fact that we have two types of options to choose from: the calls and the puts. Now, for option selling, it's worth noting that each has its own pros and cons and functions differently. Also, since we have a whole series of exit management strategies, it's even more important to understand which option will give us the most flexibility. Nonetheless, if you want incorporate the two types, your goal remains the same: leveraging the underlying security to generate cash flow by either buying the stock outright or putting cash on the sidelines to meet a possible future stock transaction.
Both option strategies have risk/reward profiles that are precisely same, but that doesn't imply both strategies are exactly similar as stated above.
Nuances For P&L Graphs
Now, isn't there one noticeable difference between an ITM put and an OTM call? Of course, and that's the risk of early assignment when you sell an ITM put I want to make you aware of. That's why most option sellers feel that covered call writing when selling an OTM call is more bullish than selling ITM puts. Let me highlight the following options chain for Argen-X, one of my favorite option selling securities to trade courtesy of sufficient implied volatility and attractive risk/reward profile (high premiums relative to downside risk protection of the time value profit). Or to put another way, most of the time these options are heavily OVERPRICED. This essential topic can be found in another article about options pricing. At the time of writing this article, shares were trading at €124.10. As highlighted in white, the deltas of puts and calls are INVERSELY RELATED and as you know (or maybe you didn't until now), delta is a Greek indicating:
the chances of a particular being IN THE MONEY at expiration
CHANGE IN THE OPTIONS PRICE if the underlying moves up or down by 1 unit
Since we're dealing with American style options, early assignment MAY occur if the delta of the option we sold is already pretty high (or increases dramatically the following days) and the time value component rather low. That's the main difference between selling an ITM put or OTM call. Also, if the price nosedives, it's cheaper to buy back a covered call than a put.
Just to draw your attention to the columns highlighted in blue and green, you'll notice that the OTM puts offer a slightly higher return than their ITM call equivalents. If we you select the OTM calls, you will be receiving slightly more time value than the ITM puts. So, there's a small difference between utilizing a call or put which is known as the SKEW.
Same Watchlist & Skill Set
Another big similarity is that we only have to screen once for both covered-call writing and put selling. Also, strike price selection and exit strategy execution are based on the same non-emotional decisions to throw the odds dramatically into our favor.
The Initial Step To Enter The Trades
The first difference relates to the initial step:
When we sell covered calls, we must first purchase at least 100 shares of the underlying security in order to be in a covered or protected position to sell 1 options contract, which is the equivalent of 100 shares. When selling the call option we are then obligated TO SELL OUR SHARES AT THE STRIKE PRICE OVER THE NEXT ONE MONTH (in case we're using one-month options). In return for undertaking this obligation, we are going to get paid by the option buyer in the form of a cash premium which is generated into our brokerage account instantaneously.
When we sell cash-secured puts, we agree to PURCHASE THE SECURITY AT THE STRIKE PRICE OVER THE NEXT ONE MONTH. In order to meet our obligation, we must keep an appropriate amount of cash in our brokerage account so that if this possible future stock transaction takes place, the cash will be there to buy the security. The amount of cash we have to put in is the amount of shares multiplied by the strike price minus the total premium received. In case you sell naked puts, your broker will allow you to come with a much lower amount of cash (20%-30% depending on the security's volatility).
Covered-call writers already own the underlying security, which makes this option selling strategy covered. From the put seller's point of view, you have the cash to possibly purchase the stock at the strike price. If you are long-term buy and hold investor, you may have been owning shares of a decent dividend-paying blue chip stock for decades and occasionally sold OTM call options to generate some additional income while getting your hands on further upside potential up to the strike price. If there's a stock trading at fire sale prices, you may want to sell deep OTM long-term puts to eventually get the stock at an even higher discount to current market value.
Exit Strategy Execution
Having touched upon the deltas, that implies there's yet another difference between selling puts and calls: the bouncing back strategy ONLY APPLIES TO COVERED CALLS because we can then buyback the call option at 20%/10% of its original value in the first half or latter part of the contract period. Conversely, a massive drop in share value would turn our short puts out.
Another difference relates to whether or not you will receive the dividends. Selling covered calls means we already own the underlying security and therefore receive the dividend if there's an upcoming ex-dividend date PRIOR to expiration. Stated differently, as long as we own the shares on the ex-dividend date, we get the dividend. There's one scenario you'd better think about for a second, and that's when your call options are IN THE MONEY and the dividend is greater than the time value component left in that option. That may result in early assignment, but that also intimates we've maxed out our trade and we can now opt to enter a completely new trade. In essence, we have to determine what our goal is whether it is dividend capture or maximizing our profits. To me, early assignment means nothing if I did the math and figured out that this was an appropriate strike and trade to move forward with.
If we sell a put, we don't purchase the stock outright which means we don't get the dividend. However, because of put-call parity, we will be returned a higher premium compared to the covered call writer, so it boils down to the fact that options fully factor in SHORT-TERM dividends.