Covered Calls and Protective Puts

Why this matters

Two suggestions about options are often made to people who own shares. One is "earn extra income on shares you already own." The other is "protect your shares against a fall." Both are real strategies with respectable names, and both are usually described by their benefit alone. Each has a cost that the earlier lessons make it possible to see exactly. This lesson describes how the two work. It doesn't recommend either.

The covered call

A covered call is selling a call option while owning the underlying shares. It generates income, the premium, with the risk of losing the shares' appreciation if the option is exercised and the shares have to be sold.¹ "Covered" means the writer already holds what they'd have to deliver.

Dana owns 100 shares of STU Corp, bought at $50. She sells one three-month call with a strike of $55 for $2 a share, collecting $200.

STU at expiration	Shares alone	Shares with the call sold	Difference
$30	−$2,000	−$1,800	+$200
$40	−$1,000	−$800	+$200
$48	−$200	$0	+$200
$50	$0	+$200	+$200
$55	+$500	+$700	+$200
$60	+$1,000	+$700	−$300
$70	+$2,000	+$700	−$1,300

Up to $55, Dana is $200 better off than with the shares alone. Above $55 her gain stops at $700, however high STU goes, because she has to sell at $55.

Three numbers sum it up. The break-even falls from $50 to $48. The most she can make is $700, a 14% gain. The most she can lose is $4,800, if STU goes to zero, against $5,000 for the shares alone.

The options disclosure document states the trade without decoration: the writer of a covered call forgoes the opportunity to benefit from an increase in the value of the shares above the exercise price, but continues to bear the risk of a decline.² For $200, Dana sold all of the upside beyond $55 and kept all of the downside but $200.

What the income really is

A premium of $200 on $5,000 is 4% in three months, and it's tempting to multiply by four and call it 16% a year. That figure assumes the shares never fall and never get called away at a price the owner regrets. The premium isn't interest. It's the market's price for the gains being given up, and Implied Volatility explains how that price is set: by the size of move the market expects. A fat premium means the market thinks a big move is likely, in which case the upside sold is worth a lot and the downside kept is real.

Repeated over many periods, the pattern follows from the shape. In quiet or gently falling markets the covered call does a little better than the shares. In strong markets it lags, sometimes badly, because the best months are the ones that get capped. In crashes it loses nearly as much as the shares. The strategy trades away the large gains and keeps the large losses.

The same position by another name

Compare Dana's covered call with a different trade altogether: owning no shares, and selling a three-month $55 put for $6.50.

The two columns differ by $50 at every price, which is about the interest on the money tied up in the shares. Otherwise they're the same position: a capped gain and a loss that grows as the share falls. Selling a put sounds risky and writing a covered call sounds prudent, and they're one trade. A put written with enough cash set aside to buy the shares is called a cash-secured put, and its writer is still subject to a risk of loss if the shares decline.²

The protective put

A protective put adds a purchased put to shares already owned. The put insures the shares' value, and the choice of strike decides where the protection begins. If the shares stay strong, the investor still has the gains.³

Dana, with her 100 shares at $50, instead buys a three-month put with a strike of $45 for $1.50 a share, paying $150.

STU at expiration	Shares alone	Shares with the put	Difference
$30	−$2,000	−$650	+$1,350
$40	−$1,000	−$650	+$350
$45	−$500	−$650	−$150
$50	$0	−$150	−$150
$60	+$1,000	+$850	−$150
$70	+$2,000	+$1,850	−$150

Whatever happens to STU, Dana can't lose more than $650: the $500 fall to the strike plus the $150 premium. Above $45 she's $150 worse off than with the shares alone.

It works like insurance with a deductible. The first 10% of any fall is Dana's. Beyond that the put pays. A higher strike means a smaller deductible and a bigger premium: a $50 put would have covered every dollar of decline and cost $3.40 a share, 6.8% of the shares' value for three months.

What the protection costs

The $150 buys three months. The passage of time works against this strategy,³ and when the put expires the protection is gone. Keeping it means buying another, at whatever the market then charges.

• Renewed four times a year, a 3% premium costs about 12% of the shares' value annually, for cover that only starts after a 10% loss. That's on the scale of the whole return an investor might hope for from the shares.
• It costs most when it's most wanted. Put premiums rise with implied volatility, and implied volatility rises when markets are frightened. Insurance bought after the fire has started is expensive.
• There's a cheaper way to get most of the effect. An owner worried about a fall can sell some of the shares. Holding 70 shares and $1,500 of cash loses $1,400 if STU drops to $30, with no premium and no expiration. It also gains less if STU rises, which is the same trade the put makes, at a different price.

A protective put earns its cost in narrower cases: a large holding that can't easily be sold, a specific period of known danger, or a floor that has to be certain.

The same position by another name

Shares plus a $45 put have a limited loss and an unlimited gain. So does a call. Buying a three-month $45 call for $6.85 and keeping the rest of the money in cash produces a loss of at most $685 and a gain of $1,815 at $70, within $35 of Dana's protected shares at every price. An investor who'd never buy calls because they're speculative, and who holds shares with protective puts, owns the same payoff.

The collar

The two can be combined. Dana keeps her shares, buys the $45 put for $1.50, and sells the $55 call for $2.00. The call's premium pays for the put, with $50 left over. This is a collar.

STU at expiration	Shares alone	Collar
$30	−$2,000	−$450
$45	−$500	−$450
$50	$0	+$50
$55	+$500	+$550
$70	+$2,000	+$550

The result is boxed in between a loss of $450 and a gain of $550. The protection looks free because it was paid for with the upside.

A collar turns shares into something closer to a short-term bond with a little variation. That can be exactly what's wanted for a holding that must be kept for a while and can't be allowed to fall. It's a poor way to own shares for the long run, since the long run's returns come from the gains above the cap.

Key takeaways

• A covered call collects a premium for giving up gains above the strike. The risk of a fall stays with the owner, less the premium.
• A covered call has the same payoff shape as selling a put.
• A protective put limits the loss to the gap down to the strike plus the premium, and the premium recurs each time the put expires.
• Shares with a protective put have the same payoff shape as a bought call plus cash.
• A collar pays for the put by selling the call, limiting both the loss and the gain.
• These strategies change the shape of results. They don't add return.

Check your understanding

An investor owns 100 shares bought at $80 and sells a call with a strike of $85 for $3 a share. At expiration the shares are at $95. What's the result, compared with just holding the shares?

1. A gain of $1,800, which is $300 more than the shares alone.
2. A gain of $1,500, the same as the shares, plus $300 of income.
3. A gain of $800, which is $700 less than the shares alone.

An investor buys a protective put every three months, paying 3% of the shares' value each time. Over five years the shares rise steadily and never fall far. What has the protection done?

1. Cost about 12% of the shares' value each year and never paid out.
2. Cost nothing in the end, since unused premiums are refunded.
3. Added to the return, since the puts gained value as shares rose.

What's next

The module's last lesson, The Major Risks of Options, gathers the ways options go wrong for the people who use them, from leverage and time decay to margin and the plain difficulty of being right twice.