It's a common misunderstanding that all options trading strategies are risky, complicated, and suitable only for speculators. While this is true for some options strategies, many strategies—such as covered calls and covered puts—can be used to hedge and help minimize the risks of trading. In fact, when employed correctly, covered calls and covered puts can potentially increase profits and limit losses simultaneously. Let's find out how.
Covered calls: Long stock position and short calls in equal quantity
Covered calls, one of the most common and popular option strategies, can be a great way to generate income in a flat or mildly uptrending market. A covered call is when you own the underlying stock and then sell someone the right to buy the stock if the strike price is reached before expiration.
Covered calls also offer limited risk protection. The protection is confined to the amount of premium received, but this can sometimes be enough to offset modest price swings in the underlying equity.
A covered call writer typically has a neutral to slightly bullish sentiment. In many cases, the best time to sell covered calls is either when establishing a long equity position (buy/write), or once the equity position has already begun to move in your favor.
When creating a covered call position, it is generally best to sell options with a strike price equal to or greater than the price you paid for the equity. If you sell out-of-the-money calls and the stock remains flat, declines in value or even increases a little, the calls will likely expire worthless and you'll get to keep the premium you received when you sold them, with no further obligation. If you sell at-the-money calls, and the stock declines in value, the options will expire worthless with essentially the same result. Once that happens, you can do it all over again for another month.
If the stock appreciates in value to slightly above the strike price, you'll probably have your stock called away at the strike price, either prior to or at expiration. This is not a bad thing. If you sold at-the-money or out-of-the-money calls, the trade will generally be profitable, and the profit will usually exceed what you would have made by buying the stock and selling it at the appreciated price.
Here's a hypothetical example of a covered call trade. Let's assume you:
- Buy 1,000 shares of XYZ stock @ 72
- Sell 10 XYZ Apr 75 calls @ 2
Because you bring in two points for the covered call, it provides two points of immediate downside protection. In other words, you will not have a loss unless the stock drops below $70.
But there's always a downside, and in this example the trade-off is that you limit the upside profit potential beyond a price of $77. So you would only want to do this if you think the price of XYZ will not exceed $77 by the April expiration. If XYZ does increase above $77, the stock purchase alone would have been more profitable.
Look at the profit and loss chart below. Notice that:
- The breakeven price is $70.
- The profit is capped at $5,000 for all prices above $75, i.e.:
- $3 x 1,000[shares stock] + $2 x 10[options contracts] x 100[options multiplier]
- The stock can drop two points before you go into the red. Losses will be incurred below $70 to zero.
- Losses could be as much as $70,000 if the stock price drops to zero, but they will always be $2,000 less than the stock trade alone.
Note: Chart depicts strategy at expiration.
Covered puts: Short stock, short puts in equal quantity
Covered puts work essentially the same way as covered calls, except that the underlying equity position is a short instead of a long stock position, and the option sold is a put rather than a call.
A covered put writer typically has a neutral to slightly bearish sentiment. Selling covered puts against a short equity position creates an obligation to buy the stock back at the strike price of the put option.
Just like with covered calls, the best time to sell covered puts can be either at the same time a short equity position is established (sell/write), or once the short equity position has already begun to move in your favor.
Here's a hypothetical example of a covered put trade. Let's assume you:
- Sell short 1000 shares of XYZ @ 72
- Sell 10 XYZ Apr 70 puts @ 2
Take a look at the profit and loss chart below. Notice that:
- The breakeven price is $74.
- The profit is capped at $4,000 for all prices below 70, i.e.:
- $2 x 1,000[shares stock] + $2 x 10[options contracts] x 100[options multiplier]
- Even though there are two points of price protection against an increase in the stock price, losses will be incurred above $74.
- Losses could be unlimited if the stock price continues to increase, but they will always be $2,000 less than the stock trade alone.
You would want to employ this strategy only if you think the price of XYZ will not fall below $70 by the April expiration. If XYZ does fall below $70, the short stock trade alone would be more profitable.
Note: Chart depicts strategy at expiration.
While covered calls and covered puts limit risk somewhat, they cannot eliminate it entirely. With that in mind, here are a few cautionary points about these strategies:
- Profits. Covered options usually prevent significant profit potential if a stock moves substantially in your favor. Anytime you sell a covered option, you have established a minimum buying price (covered put) or maximum selling price (covered call) for your stock. Any stock movement beyond that established price creates no additional profit for you.
- Losses. Losses are limited only by the amount of premium you received on the initial sale of the option. In addition, it is rarely a good idea to sell a covered option if your stock position has already moved significantly against you. Doing so could cause you to establish a closing price that ensures a loss. So before you sell, ask yourself, "Would I be happy if I had to close out my stock position at the strike price on this option?" If you can answer "yes," you will probably be OK.
- Holding until expiration. While our examples assume that you hold the covered position until expiration, you can usually close out a covered option at any time by buying it to close at the current market price. Regardless of whether the equity part of your strategy is profitable or not, waiting until expiration will maximize your return on an out-of-the-money option; however, you are not required to do so.
- Assignment. A significant change in the price of the underlying stock prior to expiration could result in an early assignment, and if your short option is in-the-money, you could be assigned at any time. Covered calls written against dividend paying stocks are especially vulnerable to early assignment.
- Corporate events. When companies merge, spin off, split, pay special dividends, etc., their options can become very complicated. The StreetSmart Edge® trading platform has detailed information regarding the terms of adjusted options; please review it carefully before you trade them.