Option Strategies #1: Covered Calls & Protective Puts


Introduction

Covered calls and Protective Puts are the two most basic and fundamental hedged option positions that you can establish. These two are the basics and lay the ground work for understanding more complex hedged positions which can help you lower or completely limit risk by sacrificing a portion of potential profit.

Familiarity with complex hedged option positions can potentially allow you to produce income in any situation regardless of whether the price of an underlying security: increases little, increases substantially, stays the same in price, decreases little or decreases substantially. This is section #1 of my explanation of different hedged option positions.


THE Covered Call:

P/L potential for a covered call position

What is it?

A covered call is established when you write a call for an underlying security that you currently own.

Establishing the covered call position:

  1. Own shares of a security in 100-share multiples

  2. Write one call (per 100-shares that you own) option agreement to sell your shares at a strike price higher than you purchased them for.

    A majority of your income from the trade will usually be earned by this– strike price minus the price you paid.

  3. By writing that call in (2) and selling the agreement to sell your shares at a specified price, you will gain additional income.

    This additional income increases profits if the equity shares gain value, but if they don’t and they actually lose value, that income gives you some cushion so you are able to still be slightly profitable despite the value of them being less than what you paid.

When to use a Covered Call

You use this option strategy if you expect the equities you own to increase in value.

By your divine technical analysis skills you’re sure that the price is rising and you have a good idea where the next resistance will be. So, to capitalize on this you write a call at a profitable strike, where you believe the price will surpass the strike enough to justify execution by the contract purchaser.

1 – If call is exercised:

You make money on the difference between the strike and your purchase price in-addition to the premium received for writing the call. Good job! You achieved maximum profit potential for the covered call position you established!

So unless that prior to writing the call you have already made the gains you wanted to achieve on the equity shares, when you write this call you probably don’t want to write the strike price In The Money (ITM) or At The Money (ATM). UNLESS the option pricing premiums are profitable enough to justify and out-compete a small loss on the equity shares, don’t write calls where you immediately lose money on your equity from selling at the strike!

2 – What if the call isn’t exercised?

A) Not exercised, still profitable:

If the call doesn’t get exercised and the contract expires worthless for the buyer: you just made money from the premium received for selling the contract, you also have the opportunity to write more new calls for more income via premiums, and if the option expiration date was far-out you potentially made money from dividend payments while holding the stocks.

B) Not exercised, not profitable:

If the underlying asset’s price falls during the length of the contract, any total losses you might experience from your equity shares losing value is reduced by the amount of premium you received for writing the contract. Because of this, when writing a covered call you are protected from a slight price droplimited to the premium, after that, you realize all loses normally.

Scenario:

  • You bought 100 shares of XYZ stock at $100 per share a week ago.
  • Today, XYZ is trading at, let’s say, $105.
  • You write a call with a $107 strike price with an expiration date next Friday.
  • The premium for this option contract is $2 a share, so you sell the contract for $200.

Immediately you are paid $200 which you decide hold onto.

From here, two things can happen. Either, the XYZ stock rises enough for the contract buyer to execute the contract or it doesn’t.

1 – If your call contract IS exercised:

If the call is exercised it means XYZ hit $109, the break even price for the contract buyer ($107 + ($200 premium divided by 100 shares)). The buyer buys 100 shares of XYZ from you at $107. You profit $7 per share plus the $200 for writing the contract –$9 per share profit. In total, you make $900 on your $10,000 investment for the 100 shares, so 9%. Maximum covered call position profit achieved!

You do, however, forego any potential profits you could have made if XYZ increases more, and you could have personally sold those shares without any contract for more than $109. You chose to risk those potential profits for the security you have on the downside, which I’ll explain in the following section.

2- If the contract is NOT exercised:

This means that XYZ stayed below $109, the break even price, the point where the contract buyer can pay for the $200 option contract, execute it by purchasing the 100 shares of XYZ stock at $107 from you, and then go sell or hold those shares without immediately losing any money.

From here there are two different situations. Either, XYZ is above the price you paid for it ($100 a share), or it fell below that and you’re now taking a loss on each of the 100 shares of XYZ.

A) Call not exercised, position STILL profitable:

If XYZ is still above your purchase price of $100, and the contract you wrote expired. You gained $200 for writing the option and now you have the choice to sell XYZ for an immediate profit or write another call.

  • If you think XYZ is soon going to fall, you should probably sell your equity shares and lock in your current profits while you are ahead.
  • If you think XYZ is either going to stay the same or possibly rise in price, you’ll sell another call and repeat this covered call tactic.

BUT WAIT! THE PREMIUM!

  • If XYZ fell below $100 you are actually temporarily protected from losses due to the $200 premium you received for writing the contract. Because of this, you don’t actually start losing money on XYZ until it falls below $98.
B) Call not exercised, position NOT profitable:

The price decreased enough where the written call obviously expired worthless to the buyer. Cool, you just made $200. However, the decline in the underlying security’s price dropped so much that the loss on the equity shares you own now outweighs the premium received for selling the call.

You are now losing money. You should consider closing the position immediately–unless for some reason your apparent A+ technical analysis skill leads you to believe that the price will do a reversal soon and this is a temporary price drop.

What about potential dividends?

In any of the situations explained above, since you’re currently holding onto XYZ shares you have the potential to receive dividend payments for your share in equity in XYZ. I suggest that you know the dividend schedule for the company that you are buying into if this interests you.

Receiving dividends is income. It will act similar to the premium you receive. That income will increase your potential profits or reduce your losses.


THE PROTECTIVE PUT (AKA: MARRIED PUT):

What is it?

Basically the opposite of a covered call, creating a Protective Put position is established when you buy put option contracts for stocks that you currently own.

Parts of a Protected Put:

  1. You own shares of a security in 100-share multiples

2. You purchase a put option contract for each 100-shares that you own of said security.

This put contract, is an agreement from whoever wrote the put saying that if you chose to exercise your option they agree to buy 100 shares (per contract that you purchased) from you at the defined strike price. You obviously wouldn’t exercise the contract if the security was worth more than the put strike. So when the price of your security is worth less than the put strike, you make them buy XYZ shares for more than what they’re worth. This protects you in case your security falls drastically in value because your losses are contained at the strike price (minus what you paid for the contract agreement).

When to establish a Protective Put position

You establish this position when you want to put a definitive limit on exposure to risk. Though, by limiting your risk you will give up some profit potential.

Follow the example scenario for a better understanding how this works:

Scenario:

You bought 100 shares of equity of XYZ company at $100 per share last week.

You’re unsure about how XYZ stock will perform going forward so you want a little insurance in the case of a drop. Or maybe, you have no doubt that XYZ shares will in fact increase in price, but you’ve traded long enough to know that weird things happen in the market sometimes. You want to limit your loses to a defined amount. For the security of knowing and defining the maximum potential loss of your position, you are happy to give up a little of the profit potential.

You purchase a put with the strike price of $95. The put contract premium costs you $200. This means the break even price for the put is $93. AKA your maximum loss potential is a loss of $7 per share.

Two things can happen,

1 – XYZ shares increase from your purchase price:

If the price rises, lets say, to $110 per share you decide to sell XYZ and lock in profits. Because you spent $200 ($2 per share) on the put option contract, your profits are calculated as:

[Current Price of XYZ] minus the [Price you Purchased XYZ for], minus [$2], then multiplied by 100 shares.

You sell at $110 and profit $8 per share.

2 – XYZ shares decrease from your purchase price:

If the price drops anywhere between $99.99 and 95.01 you calculate your losses as:

( [$100, purchase price per share] – [Current price per share] ) multiplied by 100 shares

Keep in mind that you already spent $200 on the put, so consider that in calculating losses. Subtract $200 more from what you just calculated above.

However if XYZ price goes below $93 dollars, the income from the put you purchased increases $1 for every $1 drop in the underlying, XYZ — meaning if XYZ drops to $55 overnight, you’ll still only lose $7 per share instead of $45 per share.

Knowing you have this protection from drastic, sudden price falls is super valuable.


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About the author: Dominick Muniz
Creator, web-developer, and writer at The Trading Space.

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