Cash-Secured Puts vs Covered Calls: Which Should You Use in a Down Market?

What’s the best way to generate income when stocks are falling?

Cash-secured puts and covered calls are two of the most popular income strategies—but they behave differently in a down market. Our guide will delve into each options trading technique to determine which ones work best during a bear market cycle. One isn’t always better than the other, but covered calls and cash-secured puts have their own unique pros and cons in these market conditions.

Learn everything you need to know about how cash-secured puts and covered calls work as options strategies, including their key differences. We’ll also address the primary pros and cons of using their strategies in bearish conditions and how to choose the most ideal strategy based on your goals, risk tolerance, or current portfolio setup.

Strategy Basics—Quick Refresh

Let’s touch on cash-secured puts and covered calls to give you a quick refresher on how they are set up, the goal for using each strategy, and the possible outcomes that you will get using each of these trading techniques. Once you’re aware of the nature of these two trading strategies, it becomes easier to determine which is best suited for down markets.

What Is a Cash-Secured Put?

Cash-secured puts are an options trading strategy that involves selling a put option while maintaining sufficient cash to purchase the stock if the option is assigned. In exchange for selling the put option, the trader receives a premium upfront, which is the price of the option in the form of a payout added to the account at the onset of the trade.

Goal: Buy stock at a discount or collect a premium if it doesn’t get assigned.

There are several potential outcomes associated with this type of trade, including the put option expiring worthless if the stock price is above the strike price at expiration, which allows traders to retain their premium. The other outcome is that the put buyer may choose to exercise their right to sell the stock to the investor at the strike price if the price is below the strike by the expiration date.

What Is a Covered Call?

This options trading strategy involves the trader selling a call option on a stock they already own as a way to generate income and limit the potential downside risks. When the trader sells the call, they’re giving the buyer the right to buy the stock at the strike price on or before the expiration date. The trader is “covered” because they own the underlying stock (at least 100 shares per call option), and they can successfully fill the obligation if the call option ends up being exercised.

Goal: Collect premium while agreeing to sell at a certain price.

Several outcomes result from trading a covered call. The first scenario is that the option expires worthless, and the trader retains the premium, which occurs if the stock price remains below the strike. The other outcome is that the stock price rises to or exceeds the strike price. At that point, the option is exercised, and the trader can sell their shares at the strike. This can benefit them by limiting their profit from further price increases.

Performance in a Down Market

When considering down markets and the sluggish conditions that accompany them, such as falling prices, contraction, and consolidation, you begin to wonder how cash-secured puts and covered calls perform in those types of environments. We’ve outlined exactly how each strategy performs in a down market—there are a few similarities, but there are also some key differences worth noting.

How Cash-Secured Puts React

When cash-secured puts are used in a down market, they tend to generate income, and they provide traders and investors with the opportunity to purchase new stocks at a discounted price compared to other scenarios. The revenue that traders can make through premiums can offset losses fairly well if their trades go south.

• Reduced Chance of Staying OTM as Prices Fall—When prices drop in a down market, the put option becomes less likely to expire out of the money and more likely to become in the money. This means that down markets will usually have underlying stock prices that are below the strike price. The option would then have intrinsic value, and the buyer may exercise it.
• Higher Probability of Assignment—There’s a greater chance that the seller of the short option contract will be required to fulfill their obligation to buy or sell the underlying at the strike price on or before the expiration date.
• Premium Increases with Higher Implied Volatility—The premium that a trader will receive for selling cash-secured puts will generally increase when the implied volatility is higher in down markets. However, this comes with increased risks associated with greater volatility and requires more sophisticated risk management techniques on the part of the trader.

How Covered Calls Perform

Traders using covered calls in down markets can enjoy a steady income stream due to the premiums they collect when selling call options. Like cash-secured puts, covered call premiums can offset potential losses and reduce the volatility of the trader’s portfolio.

• Stock Value Drops = Portfolio Loses Value—In down markets, the stock value for a covered call typically drops, resulting in an overall loss of the trader’s portfolio value.
• Premium Offers Limited Downside Buffer—The covered call strategy provides some downside protection through the premium received, but it can also limit potential gains if the stock price increases. The premium doesn’t always cover losses because the losses could be significantly greater than the premium is capable of buffering against.
• Less Risk of Assignment in Downtrend—Because calls typically finish out of the money in a down market, the risk of assignment is relatively small. If, by the expiration date, the call options aren’t in the money, they will expire worthless, and the option holder is unlikely to exercise them.

Pros & Cons in Bearish Conditions

When the stock or options markets are in a downturn, what are the pros and cons of using either a cash-secured put or a covered call? Refer to the table below for insights into the benefits and drawbacks of trading with either of these strategies when the market is exhibiting bearish conditions.

Key Factors to Consider When Choosing

When choosing the cash-secured put or the covered call in a down market, what are some of the main factors you should be thinking about to know for sure that you’re using the strategy that’s best suited for the situation?

Your Market Outlook

What are you expecting from the markets shortly? Your market outlook, based on the research you’ve conducted, plays a significant role in determining whether to choose the cash-secured put or the covered call.

Are You Expecting Further Drops?

Cash-secured puts may result in better entry. Any time you sell put options, you receive a premium, which is yours to keep. If the stock price drops below the strike price, you might be obligated to buy the stock at the strike price. Your purchase price will be lower because of the premium you receive upfront from the sale, which ultimately results in a better entry point for the stock you’d like to own.

Is Your Exception for the Market to Go Sideways or for the Prices to Drop Slightly?

Covered calls can generate ongoing income, which can help keep you afloat when the markets are moving against your investments. Selling call options results in the trader receiving a premium upfront, which can provide a steady income regardless of whether the option is exercised or not. Covered calls also tend to do better in sideways markets when the stock prices are expected to remain relatively the same.

Your Portfolio Setup

What is your overall investment portfolio looking like in terms of its current setup and cash flow situation? Depending on the answer, one of these strategies will work much better than the other. Continue reading to discover what we mean.

• Lots of Cash—This is a terrific fit for cash-secured puts because the trader needs to have the money set aside to possibly buy the underlying at the strike price in the event that the option is exercised. Be sure to check out our picks for the top cash-secured put stocks to help get you started.
• Holding Long-Term Stock—Covered calls might reduce cost basis because they generate consistent income through premiums. This strategy is excellent, especially if you have a neutral to slightly bullish outlook on the stock.

Your Risk Tolerance

Think about how much you’re willing to risk in the trade—each of these strategies has a different level of risk that’s worth noting.

• Cash-secured puts generally carry less risk than the covered call because the trader is setting aside the money ahead of time to buy the underlying at the strike price if the option is exercised.
• The covered calls are the riskier of the two strategies because, although the premium collected upfront can help offset some losses, it may not be enough in the case of significant losses. If the stock drops significantly, the trader could become overleveraged in their investment and not have sufficient funds to fulfill their obligation should the option be exercised.

Implied Volatility Levels

One of the common grounds between the cash-secured put and the covered calls is that an increase in implied volatility in the markets can cause the premiums for each strategy to rise, thereby maximizing the trader’s advantage. Both trading techniques can fare well in markets that are expected to see high volatility. It drives up the price of trading, including the premium collected upfront for the sale of the calls or puts.

When to Use Each Strategy in a Down Market

If you’re still wondering when to use either of these strategies in bearish market conditions, check out this section, where we summarize the best instances for using the cash-secured put, in which you set aside money to buy the underlying, or go with covered calls, which can generate steady premium income.

Use Cash-Secured Puts When…

• You want to own a stock at a better price.
• You’re confident in the company’s long-term.
• You’re not afraid of near-term volatility.

Use Covered Calls When…

• You already own a declining stock.
• You want to lower your cost basis.
• You expect flat or slightly bearish movement.

Combine Both—The Hybrid Approach

Traders can combine a covered call and a cash-secured put strategy to accomplish different trading goals. Each of these hybrid strategies provides a dynamic approach for choppy or uncertain markets. For instance, traders can utilize covered puts, which aim to generate income through premiums while potentially offsetting losses in a short position. The strategy involved shorting a stock you own and selling put options on that same stock.

Another hybrid approach is what’s known as the “Wheel Strategy.” It involves the following steps:

1. Sell a cash-secured put option on a stock you’re interested in owning at a lower price. You gain immediate income through the premium collected.
2. If the stock price goes down to the put’s strike price and your contract goes to assignment, you buy the shares with the money you save ahead of time. It helps you acquire new stock at a better price than its market value.
3. Now that you own the stock, you can sell a covered call option against your shares, which can generate call premium income.
4. If the covered call is assigned, you can sell your shares to make a profit. Then, begin the cycle anew by selling a cash-secured put on the same stock or a different one.

Which Strategy Wins in a Bear Market?

The choice between a covered call or a cash-secured put in a down market depends on your current portfolio setup, your trading goals, and personal risk tolerance, among other factors. It’s key not to let the market choose for you—consider what you need to determine which strategy will work better for your trading plan. Each move comes with its own unique pros and cons, so choose wisely and take your situation into full consideration before making a commitment.

Remember the key principles we discussed in this guide before choosing your strategy:

• There is no one-size-fits-all answer—it depends on cash, holdings, and outlook.
• CSPs work best if you want to buy low with premium protection.
• Covered calls are great if you’re stuck holding and want cash flow.
• Don’t overlook the power of combining both.

Final Tip: Use options tools and calculators to plan your trades