If you are an investor searching for yield, you may have heard about selling cash secured puts and/or call overwrite. Both strategies appear attractive because the options seller receives money (the premium) today and might not need to do anything in the future. In addition, there is some research that suggests selling options may be profitable. Both strategies have risks that are important to consider and for some investors neither strategy may be appropriate. Rather than evaluate the appropriateness and effectiveness of option selling as an investment strategy, this article will explain some of the key differences between selling cash secured puts and call overwrite.
A European put option gives its owner the right, but not the obligation, to sell stock at a specified price (the strike) at a specified time in the future (expiration). If a put is cash secured, the account holding the option holds at least enough cash to complete the purchase. This ensures the put seller will fulfill the obligation to buy the stock if the put buyer exercises the right to sell.
A European call option gives its owner the right, but not the obligation, to buy stock at a specified price at a specified time in the future. An investor who owns stock and sells a call option uses a call overwrite strategy. Because the investor owns the stock, the investor can satisfy the obligation to sell if necessary.
Both the investor who uses call overwrite and the investor who sells cash secured puts have assets available to satisfy a potential obligation. The first key difference is that the cash secured put seller holds cash while the call overwrite investor holds stock. The interest the put seller receives on the cash depends varies by custodian, currency, and other factors. An investor who holds shares of stock may receive dividends. Some custodians and prime brokers may also pass hard to borrow fee income to stock owners.
Market forces generally cause the relative price of options to reflect interest rates, dividend rates, and hard to borrow fees. As a result, it would be unusual for the pricing for selling call options to be significantly superior or inferior to selling put options. However, if an investor’s custodian pays an unusually high (low) interest rate, the investor may prefer to sell puts (calls) because the rate is different from the market rate. Conversely, if the stock is hard to borrow and the custodian passes on an unusually high (low) amount of hard to borrow fees, it may be preferable to sell calls (puts). The right answer for the investor depends in part on the investor’s circumstances and custodian agreement.
Options on stocks are generally American style rather than European style. This gives the owner of the option the right to exercise the option before expiration if they desire.
Call option holders do not receive dividends. If a stock is expected to pay a large dividend, an American call option holder may exercise the right to buy the stock early. This would cause the call overwrite investor to miss the dividend income. It may also cause the investor to lose exposure to the stock earlier than desired. Investors can reduce this early exercise risk by actively monitoring the dividends and option value. If the expected dividends are close to the time value of the option, the investor may want to consider buying back the call option.
American put options may also be early exercised. If interest rates are high and the put option is deep in the money, a put option owner may decide to sell stock early and begin earning interest rather than waiting for the expiry date. This may result in the put option seller owning the stock sooner than expected.
Whether options are could be an appropriate tool for your investment portfolio depends on your financial circumstances and comfort with complexity. There is no one right answer for everyone. If you have questions about options strategies and how they can fit into your financial plan, please contact us at firstname.lastname@example.org.