Covered Calls Vs. Selling Puts On The SPY

Courtesy of Seeking Alpha’s “Reel Ken”

We often hear about selling covered calls to generate additional income. We also hear about selling Puts to generate income. So the question becomes: Which is a better strategy?

The first step in answering this question is to understand that, from a performance perspective, they are two sides of the same coin. That is, if you owned, say 100 shares of the SPDR S&P 500 ETF (SPY) and sold a covered call with a strike of, say $140, in theory you would get a similar result by simply selling a put option with a strike of $140. Reality is a little different.

Let’s look at why this is so. SPY is currently trading at $139.79. The January 2013 $140 strike call sells for $7.99. If SPY closed at or above $140, I would make 21 cents on SPY and $7.99 on the covered call for a total of $8.20. However, SPY pays a quarterly dividend averaging about 66 cents, and the SPY shares would earn this dividend. There are three dividend events (June, September and December) totaling $1.97. So my total return would be $10.17 ($7.99 + $0.21 + $1.97).

In contrast, the $140 strike put sells for a credit of $10.15. If SPY closes at or above $140, this total credit is earned profit and compares favorably to the $10.17 combined return from the covered call. So, the covered call and sold put are about equal.

If SPY closed below $140, the equivalence stays intact, but I’ll leave it to the reader to do the math.

What about other option expiration dates?

The September $140 strike call sells for $5.97. If SPY closed at or above $140, I would make 21 cents on SPY and $5.97 on the covered call for a total of $6.17. There are two “quarters” through September (June, September) and the two dividends equal $1.32. So my total return would be $7.49.

Now, as an alternative I could have just sold the September $140 strike put for a credit of $7.36. If SPY closed at or above $140, I would earn the entire $ 7.36 credit. This is slightly less (13 cents) than my total return on the SPY covered call of $7.49. So, it would seem that the covered call has a slight advantage at this expiry. This advantage may be illusionary. If SPY approaches the $140 call strike in September it is likely to be “called away” just before the ex-dividend date and the dividend will be lost. In that case, the PUT would have an advantage of over 50 cents.

Let’s now look at the July expiration. The $140 call sells for $4.46. The combined covered call return with SPY at or above $140 will be 21 cents in price appreciation, $4.46 in option premium and 65 cents in dividends (only June) for a total return of $5.32. Selling the July $140 put credits $5.45. This time, selling the put has a 13 cent advantage. This time the risk of an ex-dividend “call-away” is practically non-existent as the expiry is one month after the dividend. This is reflected in the more direct advantage to the put-selling strategy.

So what this tells us is that at longer expiration dates, the theory of equivalence holds, but at shorter dates reality seems to favor the put.

There are actually two indexes that track near month ATM covered calls on the S&P 500 (.BXM), and selling near month ATM Puts on the S&P 500 (.PUT) that can confirm this result.

The graph following shows their relative performance and bears out that the .PUT can have a significant cumulative advantage over .BXM for ATM options.

This analysis utilized options at the money. A similar analysis can be employed to compare the two strategies for OTM and ITM options. The only caveat is to consider the likelihood of SPY being “called away” if the covered call strategy uses deep ITM calls.

There is one more factor that must be considered — taxes. If the investor is using an IRA or other tax-sheltered account, they need only deal with the direct comparison of values. On the other hand, If the investor is trading in a taxable account, there are tax considerations as follows:

1) Selling puts always results in either short-term gains or short-term losses.

2) The Dividend component of the covered call strategy, under current law, can be afforded favorable long term capital gains tax rates.

3) Gains on the SPY are available for favorable long term capital gains treatment (if held for more than a year).

If SPY moves down, it really doesn’t matter which strategy you employ.

The covered call strategy has a tax advantage if SPY moves up and you roll the calls forward for at least one year. For example, let’s say, using the January 2013 expiry that SPY closes at $155 and you’ve held it for a year, or roll over the call to achieve the one-year holding period. The calls reduce your basis in SPY and when SPY is subsequently sold, it will be taxed at the favorable long term cap-gains rate.

Though I won’t go into it, there are ways to bifurcate the transactions into some short term losses and some long term gains, but the wash-sale rules on options makes it a tightrope walk.

Conclusion: Covered calls and selling puts can be effective methods to increase overall yield. They are theoretically two sides of the same coin. However, there are times when one side is favored over the other, and a simple math analysis will yield the favored one. Shorter terms seem to favor selling puts, and taxable accounts can favor covered calls.

These little differences, accumulated over the long run, can make a significant difference. After all, if the objective is to pick up extra income, then why not consider the possibility that one strategy will actually pick up extra income over the other.