Hey traders,
In my last few articles, I’ve shown you three different ways to generate cash flow using AVGO as an example from March to the present (July 2024).
If you missed them, you can catch up here:
- Using AVGO to Generate Cashflow with Covered Calls
- Generating Cashflow with AVGO + Credit Spreads
- AVGO + Naked Puts for Cashflow
As promised, today I’m going to compare the pros and cons of each strategy, giving you a helpful way to determine which is the best fit for your goals, needs, and resources.
Let’s dive in:
Covered Calls
- PROS:
- Never expires – Because you own the stock, it’s an asset you own and can use to generate cash flow by selling options. Unlike an option, it can never expire.
- Cushion against price drops – Because you can sell call options against the stock, you can collect cash, which can offset some of the paper losses when the stock takes a temporary dip.
- Lower your cost basis – In the best case scenarios, you’ll sell multiple covered calls against the stock before you’re called away. This can greatly increase your profit versus just owning the stock and waiting for it to go up.
- Flexibility – Works in various market conditions, but works best when the market is neutral to bullish (but not too bullish)
- CONS:
- Capital intensive – This is a fancy way of saying “it’s expensive to get started.” Since you need to buy 100 shares of the stock for every covered call you sell against it, you will need enough cash up front to cover 100x the share price. For stocks in the upper hundreds or thousands of dollars, this can get expensive.
- Limited upside – Because you’re selling covered calls at a certain strike price, if the market is on a bullish tear, you could end up selling the stock at a lower price than if you hadn’t sold covered calls. This is only a “problem” if you want to extract every last dime from your stock. In my opinion, over time the safety that covered calls gives you far outbalances the “once in a blue moon lottery ticket” you could have cashed in.
- Getting stuck with a loser – Because you own the stock, if the share price drops too much, you could be stuck with an “albatross” around your neck — meaning that you’ve got a stock that is so far below your cost basis that you have to to the “dangerous” thing and sell covered calls below your cost basis.
Credit Spreads
- PROS:
- Cheap to get into – You don’t need to spend a lot of cash to get into these trades. In fact, you don’t spend any cash at all. You collect money up front in exchange for taking a risk that the stock won’t fall below your strike price by the expiration date.
- Max loss is well defined – You know your maximum loss before you enter the trade. Your max loss is limited to the difference between strike prices, minus the credit you collect.
- Versatile – We didn’t talk about this in my AVGO example, but you can play spreads in either direction. In the AVGO example, we only talked about bullish credit spreads — selling puts while betting the stock will be bullish or neutral — but you can do the opposite and sell calls if you expect the stock to be bearish or neutral.
- Stack the odds in your favor – With spreads, you don’t have to be exactly right. As you saw in the AVGO example, the stock can go up, sideways or even a little bit down. As long as the price doesn’t drop below the strike you sold by the expiration date, you keep the full premium you collected.
- CONS:
- They expire – It’s both a blessing and a curse. A blessing because we collect money up front and unless the stock makes big moves, time decay quickly eats away at the value of the spread. (that’s bad for the options buyer, but good for us) But it can also be a curse, because if a stock takes a temporary dip and your bullish spread expires during that dip, you’re done. Even if the stock recovers later, your spread has expired. Unlike when you own the stock, you don’t have anything you can cashflow.
- Limited profit – Similar to how your max loss is known in advance, your max profit is also known in advance. It’s the amount you collect up front. No matter how much the stock moves in your favor after that, you won’t get paid any more.
- “Risky” – I put this one in quotes because some people consider credit spreads to be risky since you only collect a small amount up front, but take on a much larger risk. For example, you might collect $25 for 1 contract on a weekly spread, but if the trade moves against you, you could lose $500. As you scale up the money you collect, your risk goes up proportionally, so if you collect $250, you could be risking $5000. The flip side is that the vast majority of the credit spreads I place close as winners, so take this one with a grain of salt.
- Less simple – I hate to list this one, because too many traders are scared of spreads. But it’s technically true. Spreads are slightly more complicated than buying the stock or buying a put or call option.
Naked Puts
- PROS:
- Income generation – Collect cash up front without having to buy the stock (but remember, you will have to have that amount of cash available, or 20% if you are trading on margin)
- “Income Wheel” – If you get assigned the stock, you can immediately start selling covered calls against it.
- Enter at a discount – Because you collect cash up front, if you actually WANT to own the stock, you can consider that selling naked puts gives you a way to get the stock at a discounted price. Your cost ends up being the strike price you’re assigned at, minus the premium you collected up front.
- Unlimited upside – If you sell multiple naked puts without getting assigned, you could count that as part of lowering your cost basis, so if you ever do get assigned the stock, you could be starting with a super low cost basis. Similarly, if the stock takes off like a rocket, you now own it free and clear (unless you’ve sold covered calls against it, which would cap your gains).
- CONS:
- Capital intensive – Similar to covered calls, you need to have the cash on hand. Unlike covered calls, you won’t be using this cash right away — only if you get assigned the stock. But you still need to have this cash available (or, again, 20% + margin)
- Getting stuck with a loser – If a stock falls too much, you might end up on the hook buying the stock for a price well above market price. This could start you off deep in a hole, which is never a good place to start a trade. Thankfully, this is rare, especially when you only trade trending stocks like I do.
Comparison Table
To make it even easier, here’s a table comparing the key attributes of each strategy:
| Attribute | Covered Calls | Credit Spreads | Naked Puts |
|---|---|---|---|
| Owns Underlying Stock | ✔️ | ❌ | ❌ |
| Requires Significant Capital | ✔️ | ❌ | ✔️ (or margin) |
| Limited Max Loss | ❌ | ✔️ | ❌ |
| Generates Immediate Cashflow | ✔️ | ✔️ | ✔️ |
| Works in Bullish Trends | ✔️ | ✔️ | ✔️ |
| Works in Bearish Trends | ❌ | ✔️ | ❌ |
| Long-Term Holding Potential | ✔️ | ❌ | ✔️ (if assigned) |
| Downside Protection | ✔️(some) | ✔️ (some) | ✔️ (some) |
| Flexibility in Market Conditions | ✔️ | ✔️ | ✔️ |
| Profit Potential | Limited | Limited | High |
Summary
As you can see, each strategy has unique benefits and drawbacks.
Your choice depends on your available capital, risk tolerance, and trading goals.
In short:
Covered Calls: Great for those who can afford to own the underlying stock and want to generate steady cash flow. Offers downside protection through premium collection but has limited upside and requires significant capital.
Credit Spreads: Ideal for those with less capital who want limited risk exposure and flexibility to trade in both directions. Offers defined risk and is capital efficient, but has limited profit potential and time decay can be both a blessing and a curse.
Naked Puts: Allows you to earn premium without needing to buy the stock upfront. Requires significant capital on hand (or margin) and carries the risk of getting assigned the stock. But this strategy can be beneficial if you want to own the stock at a lower price.
An Important Reminder
Don’t ever forget that you can always paper trade these strategies before you get started.
It’s a great way to get practice and see how things work in reality.
Because it’s one thing to read about it, but it’s another story when you get in there and start clicking the buttons.
I hope I helped you understand the pros and cons of each strategy and which one might be best for you.
Trade well,
Jack Carter
P.S. Wall Street just flooded NVDA with a crazy amount of cash. Here’s how I plan to play it! (see if you can guess which strategy I’m using on this)
