How to use protective put and covered call options
Summary: Investors looking to hedge against a declining market, or the possibility of a decline to come, might consider using protective put option strategies. Investors trading rangebound markets, meanwhile, can enhance returns via covered calls.
The U.S. exchange-traded equity options market dates back to 1973 and traded over five billion option contracts in 2018. It offers investors options on stock, indexes and ETFs.
To learn more about what an option is and how it works, click here.
Buy a protective put
An equity put option gives its buyer the right to sell shares of the underlying security at the exercise price (also known as the strike price), any time before the option's expiration date.
Protective put options can help protect against a declining market. If you think your investments could be impacted by a market downturn and would prefer to maintain your equity investments, you could consider purchasing protective put.
The investor could purchase an at-the-money put, i.e. with an exercise price at or near the current market price of the underlying stock. If the price of the underlying stock declines below the exercise price, the profit on the purchased put option will offset some or all of the losses on the underlying stock held. Click here for more details.
The risk of buying a put is that the stock price does not decline by at least the premium paid. If the stock price remains at the same level as when the put option was bought, then the premium paid (plus fees) will represent a loss.
The choice of strike price determines where the downside protection 'kicks in’. Buying an out-of-the-money put (i.e. with a strike price below the current market price) will be cheaper but will also offer less protection.
The covered call
Turning from protection to yield enhancement on an existing stock, let’s look at the covered call strategy.
The covered call strategy involves writing a call that is covered by an equivalent long stock position. The income received from the call option sold provides a small hedge on the stock and allows an investor to earn premium income, in return for temporarily surrendering some of the stock's upside potential.
A covered call writer is often looking for a steady or slightly rising stock price for at least the term of the option. If you’re feeling very bearish or bullish, this may not be the strategy for you.
Learn more about the covered call strategy and other strategies with The Options Industry Council’s Quick Guide.
The covered call can be a good way to enhance the return on a stock already held during sideways or rangebound market conditions. It is typically not suitable for markets experiencing dramatic up or down moves.
One way to look at the covered call is to see the premium received not only as extra income, but also as a buffer should the position not turn out as expected. For this strategy, the risk is in the stock. If the stock declines sharply, the investor will be holding a stock that has fallen in value, with the premium received reducing the loss. If the stock moves sharply higher, then the investor will be unable to participate in any upward move beyond the strike price of the call option sold, although he will also have received the premium income from writing the call.
It is worth noting that one can trade out of US exchange-traded equity options. For example, if the market rises sharply, then the investor can buy back the call sold (probably at a loss), thus allowing his stock to participate fully in any upward move. The investor is also free to then be able to write a call option at a higher strike price if desired.
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