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Managing Risk Using Options (Part 1 of a 3 part series)
By Randy Frederick, Director of Derivatives, Charles Schwab & Co., Inc.
Part 1: Covered Calls and Covered Puts
Summary: Managing risk can help you survive a bad trade to trade again another day.
Part 1 describes how to use covered calls and puts to help limit risks.
Every trader will have bad trades. But it is often said that the traders who thrive are not those who pick the most winners, but those who lose the least on their unsuccessful trades. By minimizing losses you can help ensure that you'll survive to trade another day.
Most equity traders use a variety of tools in an effort to limit losses, including stop orders, and technical tools such as crossovers and oscillator signals. But not as many are aware of how options strategies may be used to limit losses.
It is a common misunderstanding that options are only for speculators and are either too risky or too complicated to bother with. While it is true that options can be used for speculating, they are often used to hedge equity positions, and help minimize the risks of trading. It is true that there are many complex option strategies that are difficult to understand. However, there are also many strategies that are less complicated that can be effectively used by traders who have rarely, or never, traded options before.
In this three part article, we will discuss several options strategies designed to help control risk. Part 1 will focus on Covered Calls and Covered Puts. Employed correctly, these strategies can be used to potentially increase profits and limit losses simultaneously.
But before we explore these options strategies, it is important that you understand that trading options can have specific tax ramifications that you should discuss thoroughly with your tax advisor prior to trading. Also, the examples described below use regular, listed, American-style options, and do not take into account any taxes, margin requirements, or commission costs.
Covered Calls: Long stock position and short calls in equal quantity
Covered calls are one of the most common option strategies. Selling covered calls against an equity position generates premium income and creates an obligation to sell the stock at the strike price.
While covered calls can be a great way to generate income in a flat or mildly up-trending market, the limited risk protection that can be created by covered calls should not be overlooked. I say this because the protection is limited to the amount of premium received.
A covered call writer typically has a neutral to slightly bullish sentiment. In many cases, the best time to sell covered calls is either at the time a long equity position is established, or once the equity position has already begun to move in your favor.
When creating a covered call position, it is generally best to sell options with a strike price equal to, or greater than the price you paid for the equity. If the stock remains flat, declines in value, or even increases a little, an at-the-money or out-of-the-money call will likely expire worthless and you will get to keep the premium you received when you sold the covered calls, with no further obligation. Once that happens, you can do it all over again for another month.
If the stock appreciates in value, slightly above the strike price, by the expiration of the option, you will probably have your stock called away at the strike price. This could occur prior to, or at expiration. This is not necessarily a bad thing. If you sold at-the-money or out-of-the-money calls, this will generally result in a profit on the trade. That profit will usually exceed the profit you would have made had you simply bought the stock, and then sold the stock at the appreciated price.
Here's a hypothetical example of this scenario:
Let's assume we buy 1,000 shares of XYZ stock @ 72, and sell 10 XYZ Apr 75 calls @ 2. Because we bring in 2 points for the covered call, it provides 2 points of immediate downside protection. In other words, we will not have a loss unless the stock drops below 70.
As you know, there's always a downside, and in this example, the trade-off is that we limit the upside profit potential beyond a price of 77. You would only want to do this if you thought the price of XYZ would not exceed 77 by the April expiration. If XYZ did increase above 77, the stock purchase alone would have been more profitable.
If we put this combined trade example on a graph, you can see that the breakeven price is 70, and the profit is capped at $5,000 for all prices beyond 75 ($3 x 1000 [shares stock] + $2 x 10 [option contracts] x 100 [options multiplier]). You can also see that even though the stock can drop 2 points before we go into the red, losses will be incurred below 70, all the way down to a price of zero. The losses will always be $2,000 less than the stock trade alone, but could be as much as $70,000 if the stock drops to zero, compared to $72,000 if you had simply bought the stock.
Covered Puts: Short stock position and short puts in equal quantity
Covered puts work essentially the same way as covered calls, except that the underlying equity position is a short stock position instead of a long stock position and the option sold is a put rather than a call. A covered put writer typically has a neutral to slightly bearish sentiment. Selling covered puts against a short equity position creates an obligation to buy the stock back at the strike price of the put option.
Just like with covered calls, often the best time to sell covered puts is either at the same time a short equity position is established, or once the short equity position has already begun to move in your favor. Since the concept is similar, rather than repeat everything I have already stated about covered calls, let's jump right to the example.
Below is a graph showing a hypothetical example of a covered put trade in which we sell short 1,000 shares of XYZ @ 72, and sell 10 XYZ Apr 70 puts @ 2. If we put this combined trade example on a graph, you can see that the breakeven price is 74, and the profit is capped at $4,000 for all prices below 70 ($2 x 1000 [shares stock] + $2 x 10 [option contracts] x 100 [options multiplier]).
You can also see that even though there are 2 points of price protection against an increase in the stock price, losses will be incurred above 74, all the way up indefinitely. The losses could be unlimited if the stock continues to increase. In each case though, the losses would always be $2,000 less than the stock trade alone.
You would only want to employ this strategy, if you thought the price of XYZ would not fall below 70 by the April expiration. If XYZ did fall below 70, the short stock trade alone would have been more profitable.
As I'm sure you already know, there are very few risk-free profit opportunities in trading, and this is no exception. Therefore, I'd like to conclude with a few precautionary bullet points regarding Covered Calls & Covered Puts.
Most equity traders use a variety of tools in an effort to limit losses, including stop orders, and technical tools such as crossovers and oscillator signals. But not as many are aware of how options strategies may be used to limit losses.
It is a common misunderstanding that options are only for speculators and are either too risky or too complicated to bother with. While it is true that options can be used for speculating, they are often used to hedge equity positions, and help minimize the risks of trading. It is true that there are many complex option strategies that are difficult to understand. However, there are also many strategies that are less complicated that can be effectively used by traders who have rarely, or never, traded options before.
In this three part article, we will discuss several options strategies designed to help control risk. Part 1 will focus on Covered Calls and Covered Puts. Employed correctly, these strategies can be used to potentially increase profits and limit losses simultaneously.
But before we explore these options strategies, it is important that you understand that trading options can have specific tax ramifications that you should discuss thoroughly with your tax advisor prior to trading. Also, the examples described below use regular, listed, American-style options, and do not take into account any taxes, margin requirements, or commission costs.
Covered Calls: Long stock position and short calls in equal quantity
Covered calls are one of the most common option strategies. Selling covered calls against an equity position generates premium income and creates an obligation to sell the stock at the strike price.
While covered calls can be a great way to generate income in a flat or mildly up-trending market, the limited risk protection that can be created by covered calls should not be overlooked. I say this because the protection is limited to the amount of premium received.
A covered call writer typically has a neutral to slightly bullish sentiment. In many cases, the best time to sell covered calls is either at the time a long equity position is established, or once the equity position has already begun to move in your favor.
When creating a covered call position, it is generally best to sell options with a strike price equal to, or greater than the price you paid for the equity. If the stock remains flat, declines in value, or even increases a little, an at-the-money or out-of-the-money call will likely expire worthless and you will get to keep the premium you received when you sold the covered calls, with no further obligation. Once that happens, you can do it all over again for another month.
If the stock appreciates in value, slightly above the strike price, by the expiration of the option, you will probably have your stock called away at the strike price. This could occur prior to, or at expiration. This is not necessarily a bad thing. If you sold at-the-money or out-of-the-money calls, this will generally result in a profit on the trade. That profit will usually exceed the profit you would have made had you simply bought the stock, and then sold the stock at the appreciated price.
Here's a hypothetical example of this scenario:
Let's assume we buy 1,000 shares of XYZ stock @ 72, and sell 10 XYZ Apr 75 calls @ 2. Because we bring in 2 points for the covered call, it provides 2 points of immediate downside protection. In other words, we will not have a loss unless the stock drops below 70.
As you know, there's always a downside, and in this example, the trade-off is that we limit the upside profit potential beyond a price of 77. You would only want to do this if you thought the price of XYZ would not exceed 77 by the April expiration. If XYZ did increase above 77, the stock purchase alone would have been more profitable.
If we put this combined trade example on a graph, you can see that the breakeven price is 70, and the profit is capped at $5,000 for all prices beyond 75 ($3 x 1000 [shares stock] + $2 x 10 [option contracts] x 100 [options multiplier]). You can also see that even though the stock can drop 2 points before we go into the red, losses will be incurred below 70, all the way down to a price of zero. The losses will always be $2,000 less than the stock trade alone, but could be as much as $70,000 if the stock drops to zero, compared to $72,000 if you had simply bought the stock.
Note: Chart depicts strategy at expiration
Covered Puts: Short stock position and short puts in equal quantity
Covered puts work essentially the same way as covered calls, except that the underlying equity position is a short stock position instead of a long stock position and the option sold is a put rather than a call. A covered put writer typically has a neutral to slightly bearish sentiment. Selling covered puts against a short equity position creates an obligation to buy the stock back at the strike price of the put option.
Just like with covered calls, often the best time to sell covered puts is either at the same time a short equity position is established, or once the short equity position has already begun to move in your favor. Since the concept is similar, rather than repeat everything I have already stated about covered calls, let's jump right to the example.
Below is a graph showing a hypothetical example of a covered put trade in which we sell short 1,000 shares of XYZ @ 72, and sell 10 XYZ Apr 70 puts @ 2. If we put this combined trade example on a graph, you can see that the breakeven price is 74, and the profit is capped at $4,000 for all prices below 70 ($2 x 1000 [shares stock] + $2 x 10 [option contracts] x 100 [options multiplier]).
You can also see that even though there are 2 points of price protection against an increase in the stock price, losses will be incurred above 74, all the way up indefinitely. The losses could be unlimited if the stock continues to increase. In each case though, the losses would always be $2,000 less than the stock trade alone.
You would only want to employ this strategy, if you thought the price of XYZ would not fall below 70 by the April expiration. If XYZ did fall below 70, the short stock trade alone would have been more profitable.
Note: Chart depicts strategy at expiration
As I'm sure you already know, there are very few risk-free profit opportunities in trading, and this is no exception. Therefore, I'd like to conclude with a few precautionary bullet points regarding Covered Calls & Covered Puts.
- These strategies will limit significant profit potential if a stock moves substantially in your favor.
- While these strategies do limit risk somewhat, they cannot eliminate it entirely.
- Losses are only limited by the amount of premium you received on the initial sale of the option.
- Anytime you sell a covered option, you have established a minimum buying price (covered put) or maximum selling price (covered call) for your stock. Any movement in the stock beyond that established price creates no additional profit for you.
- Selling a covered option when your stock position has already moved significantly against you could cause you to establish a closing price that ensures a loss to you.
- To ensure that you do not lock in a losing trade always ask yourself the question, "Would I be happy if I had to close out my stock position at the strike price on this option?" If you can answer yes to this question, you will probably be OK.
- While our examples assume that you hold the covered position until expiration, you can usually close out a covered option at any time by buying it to close at the current market price.
- Regardless of whether the equity part of your strategy is profitable or not, waiting until expiration will maximize your return on an out-of-the-money option, but you are not required to do so. In addition, a significant change in the price of the underlying stock prior to expiration could result in an early assignment.
- Keep in mind that if your short option is in-the-money, you could be assigned at any time.
- Finally, be very careful before you decide to sell a covered option that has been adjusted due to a reorganization of the company.
- When companies merge, spin-off, split, pay special dividends, etc., the options of that company can become very complicated.
- With adjusted options, if you see a deal that just seems "too good to be true", it almost always is.
- When companies merge, spin-off, split, pay special dividends, etc., the options of that company can become very complicated.
To access a full list of options-related articles available free on the Schwab Active Trader website click here.
For information on Schwab's options trading tools and platform, please call 1-800-433-9947.
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