Covered Call Vs. Short Put
Both the covered call and short put are stock option trading strategies designed to generate a steady stream of income. The two strategies will provide similar returns to the investor. The short put trader has the option whether to sell the puts on the margin or have the trade cash secured. The covered call trade is secured by the underlying stocks. Both strategies work in a level to slightly rising stock market.
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Covered Call Explained
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A covered call trade involves buying 100 shares of stock and selling one call option contract against those shares. For example, a trader buys 100 shares Hewlett Packard at $47.20 per share and sells one three month call option with a premium of $1.40 and a strike price of $50. The trader pays the net cost of $45.80 times 100 or $4,580 plus commissions. If HPQ remains unchanged, the trader earns the $140 call premium. If HPQ is above $50 when the option expires the shares will be called away at $50 and the trade earns $420 or 9 percent in three months.
Short Puts
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A short put trade is selling put options. A put seller must deliver the stock at the strike price if the share price drops below the strike price. The goal of put selling is to have the stock stay level or go up and keep the premium received for shorting the put contracts as profit. Short puts can be cash secured with the money required to deliver the stock segregated in the brokerage account or the puts can be purchased on the margin and only a portion of the possible cost to pay off the put if it is exercised must be deposited by the trader.
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Equivalent Trades
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A covered call trade and cash secured short put trade are called equivalent options trades. The possible return percentages and risk of loss are the same for the two option strategies. Selling puts without putting up the cash cover the cost of stock is called naked short puts. Naked put selling allows a higher profit potential on the same amount of account balance. The risks of naked short puts is also proportionally higher.
Trader Considerations
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Covered call or cash secured short put trades can be accomplished in a cash or margin brokerage account with the lowest level of option trading authorization. Naked put selling can only be done in a margin account and requires a higher level of trade authorization. The higher authorization is only given to traders with extensive trading experience and larger account balances. Covered call trades are usually easier to conceptually understand. Short puts will incur lower trading commissions in most circumstances.
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