Are you looking for a simple yet effective way to dive into options trading? Two popular strategies – the covered call and the protective put are perfect starting points to explore the potential of this market. In this article, Options Alerts will guide you step by step through these strategies, making them easy to understand and apply. Whether you’re aiming to generate passive income or protect your portfolio from risk, this guide is tailored for you.
How does a covered call work?
A covered call is a popular options trading strategy that combines stock ownership with selling call options. Here’s how it works: an investor owns shares of a stock and simultaneously sells a call option on those shares. The call option gives the buyer the right to purchase the stock at a predetermined price, known as the strike price, within a specific timeframe.
This strategy allows investors to generate additional income through the premium from selling the call option. However, the trade-off is that the stock’s upside potential is capped at the strike price if the call is exercised. Covered calls are typically used by investors who expect the stock to remain stable or experience only slight price increases.
This method allows traders to reduce risk exposure while earning steady returns, making it ideal for conservative investors looking to optimize their portfolio’s performance.
Profit from Covered Call
The maximum profit of the Covered Call strategy is determined by adding the option premium to the difference between the current stock price and the strike price. With this strategy, investors earn income from selling the option and benefit from the stock’s price appreciation. However, the profit is capped at the strike price. This makes it ideal for optimizing income in a stable market.
The risk of loss in the Covered Call strategy occurs when the stock price falls below the initial purchase price. The maximum loss happens if the stock price drops to zero. While the premium received from selling the option can help offset some of the loss, it is not enough to fully compensate for it.
Example
You own 100 shares of XYZ company, currently trading at $70 per share. To generate additional income, you sell a covered call with a strike price of $75 and collect a call premium of $4 per share. Below are three possible scenarios:
Scenario 1: Stock price remains at $70 per share
In this case, the stock price remains unchanged, and the call option buyer will not exercise it because the strike price ($75) is higher than the market price ($70), making the option out of the money. You will not gain any profit from the stock but will keep the $4 per share premium.
Scenario 2: Stock price rises to $80 per share
If the stock price increases to $80, the buyer will exercise the call option since the market price ($80) is above the strike price ($75), making the option in the money. You will sell the shares at $75 per share (the strike price) and keep the $4 per share premium. While you miss out on the opportunity to sell at the higher market price ($80), you benefit from the additional income and reduced risk.
Scenario 3: Stock price drops to $60 per share
If the stock price falls to $60, the call option will expire worthless, just like in the first scenario, because the strike price is higher than the market price, making the option out-of-the-money. However, the stock value decreases by $10 per share. The $4 per share premium partially offsets this loss, resulting in a net loss of $6 per share.
How a Protective Put Work
A protective put is an options strategy that helps protect an investment from potential losses while allowing for upside potential. This strategy involves buying a put option for a stock or asset you own with a strike price below a current cost. If the stock price drops, the put option increases in value, offsetting losses in the stock. On the other hand, if the stock price rises, the investor can still benefit from the price increase, but the cost of the put option acts as an insurance premium. This strategy is beneficial in volatile markets, helping to reduce risk without losing the opportunity for gains.
Profit from Protective Put
The maximum profit of a protective put strategy is unlimited. This is because, while the put option provides downside protection, the underlying asset (usually a stock) can rise in price without limit. As the stock price increases, the value of the stock grows, and the put option, which serves as insurance, does not limit the potential gains.
On the other hand, the maximum loss is limited to the cost of the put option plus any potential loss in the underlying asset, but only if the stock price falls significantly. If the stock price drops below the put option’s strike price, the loss is capped at the difference between the stock price and the strike price minus the premium paid for the option. Therefore, the maximum loss is the cost of the put (the premium paid) plus any decrease in the stock price that exceeds the strike price. This makes the protective put a low-risk strategy for investors seeking protection while maintaining exposure to market gains.
Example
You own 100 shares of ABC company, currently trading at $50 per share. To protect your investment from potential downside risk, you purchase a put option with a strike price of $48 at a set premium of $2 per share. Below are three possible scenarios:
Scenario 1: Stock price remains at $50 per share
If the stock price does not change, the put option will not be exercised because the strike price ($48) is below the market price ($50), making the option out of the money. In this case, your stock retains its value but loses $2 per share paid as the put premium.
Scenario 2: Stock price rises to $55 per share
If the stock price increases to $55, the put option will remain out of the money and will not be exercised. You benefit from the $5 per share gain in stock value but lose $2 per share paid for the put premium, resulting in a net gain of $3 per share. The premium serves as insurance for downside protection.
Scenario 3: Stock price drops to $40 per share
If the stock price falls to $40, the put option will be exercised because the market price ($40) is below the strike price ($48), making the option in the money. You sell the stock at the strike price of $48 instead of incurring a more significant loss at the market price. After deducting the $2 per share put premium, your net loss is limited to $2 per share instead of $10.
Optimal Market Conditions for Covered Call and Protective Put Strategies
Understanding the optimal market conditions for specific strategies is crucial when navigating the complexities of options trading. Two popular strategies, Covered Call and Protective Put, are designed to help investors manage risk and enhance returns, but their effectiveness depends on market conditions.
In neutral or mildly bullish market conditions
The Covered Call strategy is suitable for neutral or mildly bullish market conditions. If you anticipate that the stock price will remain stable or experience modest growth, a Covered Call allows you to maximize returns by generating additional income through selling call options. This approach is particularly beneficial for long-term stockholders who do not expect a significant price increase in the short term.
However, one major drawback of this strategy is that your potential profits are capped at the strike price of the call option you sell. If the stock price rises sharply beyond your expectations, you won’t be able to capitalize on the total increase and must settle for the predetermined profit level. As a result, Covered Call is best suited for investors seeking to earn extra income during periods of low volatility and relatively low market risk.
In market downturns or periods of heightened volatility
A Protective Put is ideal when concerned about significant market downturns or heightened volatility. This strategy helps safeguard the value of your portfolio, especially when you want to minimize losses but retain ownership of the stock to benefit from its long-term growth potential.
The strength of a Protective Put lies in its ability to establish a minimum price floor, ensuring that even if the market takes a steep dive, your losses are limited to an acceptable level. However, implementing this strategy requires paying a premium for the put option, which can reduce your overall profitability if the stock price does not decline or only experiences modest growth.
Protective Put options are preferred by cautious investors who aim to preserve capital while maintaining the opportunity to benefit from a market recovery in the future. They are often considered a form of “insurance” for their portfolio during uncertain times.
Key Considerations When Using Covered Call and Protective Put Strategies
When you’re just starting with Covered Call and Protective Put strategies, there are several important things that investors need to keep in mind to maximize trading effectiveness. For the Covered Call strategy, it’s crucial to carefully consider the strike price and expiration date to avoid missing out on potential gains while also keeping an eye on the downside risk of the stock, as this strategy does not protect you from significant price drops.
On the other hand, the Protective Put strategy can help safeguard your investment, but the cost of purchasing the put option must be carefully considered. Choosing the right strike price is critical to ensure effective risk protection without incurring excessive losses if the stock doesn’t decline as expected.
At Options Alerts, we provide accurate trading signals and have a community of expert options traders ready to support you. With these strategies, you can minimize risks and optimize profit opportunities. Join our community to receive guidance and share in-depth knowledge about options trading!
