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Covered strategies

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

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

In contrast to writing naked positions, where we are selling or writing contracts without planning for assignment, we can sell covered positions. A common misconception is that a covered position is guaranteed to be less risky than a naked position. Depending on whether the position is a call or put option, this isn't always so. Instead, a better way to think of the difference between a covered position and a naked position is how the options contract is combined with the underlying.

Key takeaways:

The three takeaways for this lesson are:

  • Understand a covered call
  • Understand a covered put
  • Understand the risk associated with both

Writing a covered call

What is a 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.

Why do investors choose to write covered calls?

There are three advantages to writing a covered call.

  1. Covered calls provide us with a strategy to generate income by selling deep out-of-the-money calls
  2. Covered calls provide stability over holding stock only in the form of limited downside protection
  3. Covered calls let us get paid to sell stock at a higher price

The pitfalls of covered calls

Before we think about selling covered calls, we should consider the tradeoffs.

  1. They are expensive since the strategy requires us to own at least 100 shares of the underlying
  2. We give up the potential to make a lot of money if the stock price jumps in value

To understand the pros and cons better and why investors choose to sell covered calls, let's construct a profit diagram. We'll need to start with two diagrams since a covered call includes the underlying stock and the short call option.

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. 

Let's now can combine the two diagrams above. 

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 lost the value of the stock, but have gained 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. 


Writing a covered put

What is a Covered put?

A covered put is where we would sell a put contract and short-sell the underlying stock. Covered puts are generally not possible because brokerages won't allow us to be short on a position due to the risks and capital requirements to maintain a short. 

Why do investors choose to write covered Puts?

The main advantage of a covered put is that it requires very little money because an investor gets money upfront by short-selling stock

The pitfalls of covered put

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

Covered Put Explained | Online Option Trading Guide

In the profit diagram above, we see that losses are uncapped when the stock rises in price. We should all offer a "thank you" to brokerages like Robinhood for doing us a favor because as a beginner we don't want anything to do with covered puts.

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. 

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