Table of Contents
Options strategies can be basic or sophisticated, with one or many option contracts and, in some cases, the underlying asset. These tactics are intended to mitigate risk, speculate on volatility, and profit from specific market conditions.
Covered Calls
A Covered Call strategy involves the trader holding a long position in an underlying asset while selling a call option on the same asset. The number of shares owned by the trader should match the number of shares covered by the call options sold.
Objective:
The purpose is to make money from the option premium earned by selling the call option. This approach is frequently used by traders who have a neutral to slightly optimistic outlook on the underlying asset.
Risk and Reward:
While the premium received provides some downside protection, the biggest risk is that the underlying asset’s value may decrease, potentially resulting in a loss. However, the profit potential is capped at the strike price of the sold call option. If the underlying price rises above this level, the trader will not participate in those gains as the shares may be called away.
Assume an investor who buys a call option on a stock, with each call option equal to 100 shares of the stock. The investor would sell one call option for every 100 shares of stock they own. This method is dubbed a covered call because if the stock’s price surges unexpectedly, the short call position is offset by the ownership of the underlying stock.
Married Put
The married put strategy involves an investor buying shares of a stock or a similar asset and at the same time purchasing put options for an equivalent number of shares. Each put option contract typically covers 100 shares, granting the investor the right to sell the stock at a specified price, known as the strike price.
Objective:
The main purpose of this strategy is to protect the investor’s stock investment from significant losses due to falling stock prices, effectively serving as an insurance policy. By setting a floor on the potential losses (through the strike price of the put options), the investor safeguards their investment against drastic declines in the market value of the stock. This strategy is hence also referred to as a protective put.
Risk and Reward:
The primary advantage of a married put is the security it provides, allowing investors to limit their downside risk while still participating in the potential upside of the stock. This makes it an appealing option for investors who are optimistic about a stock’s long-term prospects but are cautious of short-term volatility or potential declines.
The main risk associated with this strategy is the cost of purchasing the put options, known as the premium. If the stock price does not fall below the strike price of the put options, the investor will not exercise the option and will lose the premium paid. This cost is the price of insurance against a significant drop in the stock’s price. Therefore, the investor’s net profit on the stock is reduced by the amount of the premium paid for the puts, but they gain peace of mind knowing their investment has a layer of protection.
The long stock position is shown by the dashed line in the P&L graph above. You can see that the losses are constrained when the stock price drops when you combine the long put and long stock bets. Above the put premium paid, the stock can, nevertheless, benefit from the upside. The P&L graph of a married put looks like the P&L graph of a long call.
