The age old question….. Should I get into Options?
For many traders, options can seem intimidating at first. There are multiple strategies, complex terminology, and risks that can be hard to grasp without a solid foundation. But it doesn’t have to be overwhelming. Two of the most beginner-friendly options strategies are Covered Calls and Protective Puts. These strategies are great for traders who want to dip their toes into options while still maintaining a relatively low-risk profile.
In this post, I’ll walk you through the basics of these two strategies, show you when to use them, and share practical examples so you can confidently start incorporating them into your trading arsenal.
What are Covered Calls?
A Covered Call is an options strategy that involves selling (or “writing”) a call option on a stock you already own. The goal is to generate additional income from the premium received by selling the call option. Essentially, you’re getting paid to potentially sell your stock at a higher price than its current market value.
When to Use It: Covered calls are best used in a neutral to slightly bullish market when you believe the stock will remain relatively flat or rise only moderately. By selling the call, you’re agreeing to sell your shares at the strike price if the option is exercised. If the stock price remains below the strike price, you get to keep the premium as profit and continue holding your shares.
Example:
Let’s say you own 100 shares of Apple (AAPL), which is currently trading at $150 per share. You decide to sell a covered call with a strike price of $160 for a premium of $2 per share. Here’s what happens:
Scenario 1: The Stock Stays Flat or Declines
If AAPL remains at $150 or drops below $160, the call option will expire worthless, and you keep the premium of $200 ($2 x 100 shares). You still own your 100 shares and can repeat the process in the next month.Scenario 2: The Stock Rises Above $160
If AAPL rises to $165, the option is likely to be exercised. This means you’ll have to sell your 100 shares at $160, but you still keep the $200 premium. The downside? You’ve capped your upside potential. You miss out on the $5 gain ($165 - $160) you could have earned if you hadn’t sold the call.
Benefits:
Generates additional income.
Lowers your cost basis on the stock.
Great for sideways or slightly bullish markets.
Risks:
Limits your upside potential.
You could be forced to sell your shares if the stock rallies beyond the strike price.
What are Protective Puts?
A Protective Put is an options strategy that acts like an insurance policy for your stock holdings. It involves buying a put option on a stock you already own to protect against a potential decline in the stock’s price. By purchasing a put, you gain the right (but not the obligation) to sell your shares at a specific price (the strike price) within a certain timeframe.
When to Use It: Use a protective put if you’re worried about a potential drop in your stock’s price but still want to hold onto your shares for the long term. This strategy is often used during times of increased market uncertainty or when a stock has had a significant run-up, and you want to lock in some profits.
Example:
Imagine you own 100 shares of Microsoft (MSFT), currently trading at $300 per share. You’re concerned about a short-term pullback but don’t want to sell your shares. You decide to buy a put option with a strike price of $290 for a premium of $5 per share.
Scenario 1: The Stock Price Drops to $270
If MSFT falls to $270, the put option will increase in value because you have the right to sell your shares at $290, even though the current market price is lower. This limits your downside risk to $10 per share ($300 - $290), plus the $5 premium you paid. Without the put, your loss would have been $30 per share ($300 - $270).Scenario 2: The Stock Price Rises Above $300
If MSFT rises to $320, the put option expires worthless, and you’re out the $5 premium. But your stock has appreciated, and you’re still holding onto your shares, so you’re happy.
Benefits:
Limits your downside risk.
Allows you to hold onto your shares even during periods of increased volatility.
Offers peace of mind in uncertain markets.
Risks:
The premium paid for the put reduces your overall profit.
If the stock doesn’t decline, the cost of the put eats into your returns.
When to Use Each Strategy
Both covered calls and protective puts have their place, but knowing when to use them is key:
Covered Calls: Use when you want to generate additional income from stocks you already own and expect the stock price to stay relatively flat or rise slightly. This strategy works well in a sideways or slightly bullish market.
Protective Puts: Use when you’re concerned about a potential decline in your stock’s price and want to protect your position. It’s ideal for long-term investors who want to stay in the market while limiting downside risk during volatile periods.
Combining the Two: The Collar Strategy
If you’re looking to combine both strategies, consider using a Collar. This strategy involves owning the stock, selling a covered call, and simultaneously buying a protective put. The goal is to limit both your downside risk and your upside potential within a specific range.
Example:
Let’s say you own 100 shares of Tesla (TSLA) at $700. You decide to sell a $750 call and buy a $650 put. Here’s what happens:
If TSLA rises above $750, your upside is capped because the call will be exercised.
If TSLA falls below $650, your downside is protected by the put option.
The premium received from selling the call helps offset the cost of buying the put, making this strategy a cost-effective way to hedge your positions.
Final Thoughts: Start Small and Stay Disciplined
Covered calls and protective puts are excellent entry-level strategies for beginners looking to enhance their trading skills. They provide a way to generate income and protect your portfolio without taking on excessive risk. But remember, as with any options strategy, it’s essential to fully understand the mechanics and risks before diving in.
Options can be powerful tools, but they require a disciplined approach and a clear understanding of your objectives. So start small, practice these strategies, and always have a plan in place.
Until next time—trade smart, stay prepared, and together we will conquer these markets!
Ryan Bailey
VICI Trading Solutions