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Using Covered Calls and Puts to Gain Trade Management Flexibility

June 2, 2011 | By

What is a Covered Call or Covered Put?

A covered call/put is an option strategy used by traders who hold a long/short futures position and sell a call/put option on the same underlying futures.  If the trader is long the futures contract, the trader will sell an out of the money call. If the trader is short the futures contract, the trader will sell an out-of-the-money put.

Why Do Traders Use This Strategy?

This strategy provides traders with an opportunity to earn additional income when the market consolidates and provides some extra cushion if the underlying futures moves against them. Under most circumstances, the strategy will be used when a trader has a directional opinion of the market. The idea behind the strategy is to take a directional position on the futures and sell an option that is out of the money to a level they feel the market will have a difficult time reaching. This allows the trader to hold their long or short position as well as take advantage of the options time decay.

Covered Call Example

Bob feels that the price of corn will increase over the next few months. Currently, corn is trading at $7.00 per bushel.  Bob buys one futures contract at $7.00.  Bob feels demand for corn is very strong at $7.00, but feels that this strong demand will begin to ration if/when the price exceeds $8.00. Based on this assumption, Bob decides to sell an $8.00 call option. By selling the $8.00 call, Bob collects 25 cents ($1,250).  The sale of the option provides Bob with a 25-cent cushion in case of an adverse move in corn.  This will give Bob a breakeven price of $6.75 on his futures contract ($7.00-$0.25= $6.75).  If the market sells off beyond $6.75, Bob will be at a loss on the trade.  If the market moves higher, Bob will be at a profit but will be limited to a max profit of $1.00 ($8.00-$7.00).

Any trades are educational examples only. They do not include commissions and fees.

Trade Management Flexibility

This strategy provides Bob with some flexibility on how he manages the trade.  If the market sells off, Bob can roll down his $8.00 call option to a call at a lower strike price. This would allow Bob to collect additional premium and lower his breakeven. For example, let’s say corn sells off by 40 cents and is now trading at $6.60. The delta on Bob’s $8.00 call is 0.25, which means that his option will decrease at a rate of 0.25 for every 1.00-point move in the futures.  So if corn were to sell off 40 cents, Bob’s call option would drop in value by about 10 cents (40*.25= 10). You can learn more about an option’s delta by reading our article “Going Greek: Understanding Your Option’s Delta”.  In this example, Bob will buy back his $8.00 call at 15 cents locking in a profit of 10 cents on the trade (25-15=10).  Bob can then sell a $7.75 call and collect an additional 20 cents. Between the profit taken on the sale of his $8.00 call (10 cents) and the additional premium collected from the sale of his $7.75 call (20 cents), Bob’s new breakeven on the futures is $6.70 ($7.00-0.30= $6.70).  This will also reduce the max profit on his position to 75 cents ($7.75-$7.00= $0.75). By using this strategy Bob is only down 10 cents on the trade. Bob’s new breakeven is $6.70 and the futures is now trading at $6.60. Had Bob only bought the futures at $7.00, Bob would be down $0.40 cents on the trade.

Any trades are educational examples only. They do not include commissions and fees.

As you can see, this strategy does not remove all risk from the trade, but it does provide an alternative to trading the outright futures contract only. Like any trading strategy, it is important to enter the trade with a predetermined game plan, remain disciplined, and stick to the plan. Managing risk will still be a key component to your overall success as a trader, but this strategy can be used to help hedge your position’s risk.

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