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Covered Calls & Covered Puts

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Covered Calls and Covered Puts attempt to reduce risk. A covered call combines a long purchase of an underlying asset with a written call. A covered put combines a short sale of an underlying asset with a written put. Both are balanced in equal amounts. If you’re long (or short) 1,000 units of the underlying investment, calls (or puts) would represent all 1,000 units. It can represent less, but should never represent more.

Covered Calls

A Long Covered Call profit loss diagram and a Short Covered Call profit loss diagram.

Long Covered Call
Short Covered Call

Covered Calls combines a long purchase of an underlying asset with written calls. This starts with a valuation or acceptable price of sale for the underlying asset. The estimated valuation price, or the acceptable sale price, is the strike price of the written call option. Whoever buys this call will have the right to buy, and you will be obligated to sell.  Note that the strike price should be higher than the current market price. The option written should be “out the money” while underlying price rises towards “in the money” status. You should not expect the underlying asset to fall.

One of two scenarios will occur depending on the underlying asset’s performance in relation to the exercise price. If the market price stays below the strike price, the calls will not be exercised. Your investment returns will be boosted by the premiums you received when you sold the options you created. If the market price equals or exceeds the strike price, the calls may be exercised. You will be obligated to sell the underlying asset. You will earn returns up to strike price plus the premium from the options written and will lose any earnings above the strike price. You will earn the maximum of the strike price, but that’s fine. When you created the option you chose a strike price that was a comfortable sales point for the investment. Additionally, you earned the premium which boosts your returns.

Covered Puts

A Long Covered Put profit loss diagram and a Short Covered Put profit loss diagram.

Long Covered Put
Short Covered Put

Covered Puts combines a short sale of an underlying asset with written puts. This starts with a valuation or acceptable purchase price for the underlying asset. The estimated valuation price, or the acceptable buy price, is the strike price of the written put option. Whoever buys this put will have the right to sell, and you will be obligated to buy. Note that the strike price must be lower than the current market price. The option is written “out the money” while underlying price falls towards “in the money” status. You should not expect the underlying asset to rise.

One of two scenarios will occur depending on the underlying asset’s performance in relation to the exercise price. If the market price stays above the strike price, the puts will not be exercised. Your investment returns will be boosted by the premiums you received when you sold the options you created. If the market price equals or falls below the strike price, the puts may be exercised. You will be obligated to buy the underlying asset. You will earn the strike price plus the premium from the options written and will lose any earnings below that price. The maximum you will earn is the return up to the exercise price. You will never profit from falls below the strike price, but that’s fine. When you created the option you chose a strike price that was a comfortable exit point for the investment position. Your short sale will be closed with the shares forcibly purchased via the put, which secures short sale profit, plus you earned premium to boost your returns.

Assumptions

The above examples assume the options and assets are held until expiration. If the options are not held until expiration the situations change, unless you are assigned. If you are assigned your options will be closed early and your position will run its course ahead of time. Early exercises against your positions are possible if you’re using American options which are at or in the money.

Cancellation

You can optionally cancel your strategy by purchasing an option opposing your position. If you wrote calls, buy calls for an equal amount of underlying assets that can be exercised at the same strike price or below it. If you wrote puts, buy puts for an equal amount of underlying assets that can be exercised at the same strike price or above it. In both cases, buying the exact same amount of sold calls or puts will close the position completely.

Gains & Losses

Lastly, be very aware of the way profit and losses interact in covered positions. As shown, you will only receive up to the strike price as profit. Beyond that, you will earn nothing. If your underlying asset moves substantially in the money beyond that point, you will not receive that potential profit. Be sure the strike price selected allows enough return. Losses, on the other hand, will be reduced by the premium received for writing the option. If the underlying asset incurs losses beyond the premium you earned, you will still incur a loss. A strike price that is already in the money when you write the option will also incur a loss. Be sure your strike price is worth opening the position.

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Option Profit Diagram Example

  • As you move to the right the underlying asset increases in value. The left side is lower in underlying price, while the right side is higher in underlying price.
  • As you move to the top the trade increases in profit. The gray horizontal line is the profit/loss difference point, the zero line where there is no profit and no loss. Higher above the line is higher in profit, lower below the line is higher in losses.
  • The blue line is the profit/loss at expiration. The purple line is the profit/loss now. Eventually the curving purple line will become the blue line.
  • A flat blue line below the grey zero line indicates limited losses at expiration. A flat blue line above the grey zero line indicates limited gains at expiration. A blue line that slopes down infinitely off the chart represents unlimited losses, while a line that slopes infinitely up represents unlimited gains.
  • A preference for limited loss trades is strongly recommended, remember that an estimated 60% to 70% of retail trader options expire worthless when purchased since prices need a reason to move in the money. If you have limited gains, they should preferably be both more likely than and higher than your potential losses. Always manage risk carefully.
  • Option diagrams created by TDAmeritrade “ThinkOrSwim” platform.