Options are popular instruments for hedging and generating extra income. One type of such financial derivatives are known as covered calls. In this article, we’ll explain what a covered call is and how you can use this type of financial derivative in your investment strategy.
What is a covered call?
A covered call means that the investor has a long position in an asset (for instance, stocks). To generate profit, they write a call option (to sell the shares if the buyer decides so). The investor writing the covered call option does so to generate extra income, in the form of the premium, or the price of the option itself. Investors do so for assets when they believe that the price of the underlying asset will have a minor change.
Hence, it is a call because the writer sells a call option, which means that the buyer has the right (but not the obligation) to buy the stocks or the assets the investor sells via the option. It is a covered call because the investor writing the option actually owns the underlying assets (such as stocks in this example).
The risk increases if the underlying asset’s price increases too much (i.e., higher than the strike price), as the buyer of the option can exercise their right to buy the assets and purchase them cheaper than the market price. The investor’s profit and risk also depend on the strike price – for instance, this could offset some losses or could increase the losses in case of major price changes.
What is a protective put?
A protective put involves purchasing a put option for the underlying asset that is already present in our investment portfolio. By acquiring a put option, we gain the right, though not the obligation, to sell the underlying asset at the predetermined strike price.
Therefore, this strategy serves as a means to safeguard against potential price declines in the underlying asset, particularly when such downturns are expected or during periods of uncertainty.
Regardless of the extent of the price decline or the size of the opening gap, our ability to sell at the specified price empowers us to exit the position at that level, even if the underlying asset’s market value falls significantly below it.
Overall, a protective put is similar to insurance – even if the stock price falls, the investor can exercise the option and sell the shares at the strike price, hence limiting their losses.
How to implement a covered call and a protective put
Assume the investor has a long position in the E-mini S&P 500 Index Futures, and these futures are the underlying asset.
Sell a call option for the same E-mini SP 500 futures that you own. By doing this, you are creating a covered call position. The call option gives the buyer the right to purchase the E-mini SP 500 futures from you at a predetermined price (strike price) within a specified time frame (expiration date).
By selling the call option, you receive a premium, which provides some income and can help offset potential losses if the price of the E-mini SP 500 futures does not rise significantly.
Alongside your long position in the mini futures of the E-mini SP 500, purchase a put option for the same underlying asset. The put option grants you the right to sell the E-mini SP 500 futures at a specific price (strike price) within a given time frame (expiration date).
The purpose of this protective put is to act as an insurance policy, providing downside protection in case the price of the E-mini SP 500 futures experiences a significant decline. If the market value of the E-mini SP 500 futures drops below the strike price, you can exercise the put option and sell them at the predetermined price, limiting potential losses.
The covered call strategy aims to minimise potential losses in your long position by receiving the premium from selling the call option. However, in return, it sets a limit on potential gains when the price of the underlying asset rises. This makes the covered call useful in several scenarios:
- Stable Underlying Price: When you expect the price of the underlying asset to remain relatively stable, the covered call can generate income through the premium without the significant risk of losing the underlying asset.
- Lock Profits: If you have a specific target price in mind and believe the underlying asset will reach that level, the covered call allows you to lock in profits by selling the call option with a strike price at or near your target.
- Establishing a Profit Level: By collecting the premium from the call option, you can set a level of taking profits that extends beyond the current price of the underlying asset.
- Various Other Strategies: The covered call strategy can be combined with other tactics, but these might require a more detailed explanation, as they involve more complex scenarios.
On the other hand, the protective put strategy aims to limit potential losses by paying the premium for the put option. It provides a floor on losses in case the price of the underlying asset decreases. The protective put is particularly beneficial when you expect the price of the underlying asset to decline, as it allows you to profit from the put option you bought.
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Covered call and protective put: summary
It’s worth noting that by employing both strategies, you can effectively create a total lock on potential losses and gains. The premium received from the covered call can offset the cost of the protective put, leaving the variation in potential benefits and losses relatively unchanged. This combination allows you to hedge your position, protecting against both upward and downward price movements in the underlying asset.
What is the main objective of the covered call strategy?
The primary objective of the covered call strategy is to provide downside protection and generate income from an existing long position in an underlying asset. By selling a call option for the same asset, the investor receives a premium.
When should I consider using the protective put strategy?
The protective put strategy is most suitable when an investor anticipates a potential decline in the price of the underlying asset. By purchasing a put option for the same asset, the investor gains the right to sell the asset at a predetermined strike price within a specific time frame.
Can I combine the covered call and protective put strategies?
Yes, combining the covered call and protective put strategies is known as a collar strategy. This approach can be effective in creating a range of potential gains and losses. By selling a call option (covered call) to generate income and using the premium to purchase a put option (protective put) for downside protection, an investor can create a capped profit and capped loss scenario.