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Covered strategies

Lesson in Course: Derivatives and options (advanced, 5min)

When writing contracts, what does it mean to write covered positions? When should I consider using this strategy?

Eureka!

What it's about: How to implement a covered call and covered put strategy and the risk involved.

Why it's important: We can unintentionally recreate the same risks as naked calls and puts.

Key takeaway: A covered call strategy is the same as a naked put. A covered put is the same as a naked call.

In contrast to writing naked positions where we are selling or writing contracts without having an offsetting position, we can sell covered options. An offsetting position satisfies the requirements of assignment, such as having enough underlying to sell to the holder in the case of a covered call.

What is Covered call?

When we own at least 100 shares of the underlying and sell a call option, we have sold covered calls. For each call option contract sold short, we need 100 shares of the underlying stock to fulfill our contractual obligation if we get assigned.

Covered call requires owning stock

If the offsetting position for a call is having the underlying to sell, what happens if we need to purchase shares for a covered put

What is Covered put?

A covered put is where we would sell a put contract and short-sell the underlying stock. 

A covered put requires short-selling stocks

A short underlying position will result in us owing shares of the underlying to our brokerage. When we are assigned and have to buy the underlying in a put contract, we return the shares we owed and our position is covered. Covered puts are generally not possible because brokerages won't allow us to be short on an underlying due to the risks and capital requirements to maintain a short. 

 

Reasons why investors use the strategy

Are there specific benefits to selling covered calls or puts?

Due to put-call parity, covered positions share some of the same benefits as naked solutions. These include: 

  1. Short theta
  2. Option legs for complex strategies
  3. Synthetic option strategies

Covered calls provide some more tangible benefits due to already owning the underlying.

  1. Generate income against our underlying positions
  2. Limited downside protection for the underlying

Selling an out-of-the-money covered call against our stock position with a strike price much higher than the current underlying price allows us to collect the premium. Simultaneously, we are getting paid while placing a sell limit order on our stock. In the case the underlying's price rises enough to trigger assignment, we have effectively sold our shares at the limit price. On the other hand, if the stock price drops in value, the money we've collected from selling the call option helps lessen our losses. A covered call provides limited insurance against price drops.

Pitfalls to avoid

A common misconception is that the offsetting position in a covered position makes it to be less risky than a naked position. Depending on whether the position is a covered call or covered put, this isn't always so.

Losses can still be quite substantial

Covered calls

 

Let's construct a profit diagram to visually see the risk. We'll need to start with two diagrams since a covered call includes the underlying stock and the short call option.

Profit diagram of the underlying and short call

 

In the two diagrams above, we can see that for the underlying shares, we profit continuously as the stock price goes up. We also lose if the stock value goes down. For the short call option, the options are out-of-the-money if the stock price drops and we get to pocket the premiums. However, if the stock price increases, we will get assigned and could face potentially unlimited losses. The advantage of a covered call is that the profit from the underlying stock offsets the losses from the short call option. 

Now, let's combine the two diagrams above. 

Covered call profit diagram and put-call parity

A covered call contract has limited potential gains and somewhat limited losses. The biggest loss we can incur is if the 100 shares of the underlying stock drop to $0 in value. In which case we lose the value of the stock, but gain the premium of the unexercised option. If the stock price skyrockets, the losses on the short call option are offset by the gains in the shares. For those of you who understand the basics of put-call parity, we'll know that a covered call is the same as a short synthetic put.

 

Covered puts

A covered put is the same as synthetically selling a naked call where the option strategy's potential losses are limitless and can bankrupt an unsuspecting writer.

Put-call-parity for covered puts

In the profit diagram above, we see that losses are uncapped when the stock rises in price. Through put-call-parity, we've created a naked call and as we would do with a naked call, this strategy should be completely avoided when we are new to options.

Actionable ideas

A covered call is the most viable strategy for a beginner. A covered call is often used in retirement accounts with long-term investments like IRAs. A generic covered call strategy includes:

  • low volatility stocks
  • short to medium durations (less than 180 days to maturity)
  • a strike price that is higher than the current stock price
  • a strike price that we would be happy to sell

While it's tempting to start trading options right away, we should really get comfortable recognizing the pay-off diagrams for different strategies before we make a trade.