Options are financial derivatives in which the price (premium) depends on the underlying asset’s price. Options were created initially for hedging, and both the covered call and the protective put are intended to protect the position taken in the underlying asset. Therefore, the covered call (sale of a call option) and the protective put (purchase of a put option) are hedging instruments when you have a long position in the underlying asset.
What Is Covered Call
The covered call consists of selling a call option on the underlying asset that we already have in our portfolio. The covered call can move the break-even (delay of entry into losses) of the portfolio since when selling an option, we enter the premium. The result of adding a short call to a long position in the underlying is a short put.
Therefore, this is a strategy that allows additional income to that of the portfolio (premium), and although when the asset experiences significant increases, this strategy slows down our profit, the correct application can make us enter continuous profits in the style of a dividend, even leaving the cost of acquiring the asset at 0.
The risk is therefore reduced with the acquisition of the premium, with the counterpart of the potential limitation in benefits if the asset rises in a trend. This profit limitation can be mitigated by choosing higher strikes and further from the underlying price, but it must be taken into account that the further the strike is, the less premium is charged.
What Is Protective Put
The protective put consists of buying an option on the underlying asset we already have in our portfolio. Buying a put gives us the right, but not the obligation, to sell the underlying asset at the strike price. The result of adding a bought put to the extended position in the underlying is that of a bought call option.
Therefore, this strategy allows you to protect yourself from falls in the underlying asset price when this is expected to occur or when there is uncertainty. It does not matter how much the price falls nor the size of the opening gap, our right to sell at a specific price will allow us to exit the position at that level even if the underlying is trading at a much lower price.
The consequence of adding a bought put when owning the underlying asset is to secure the position in the underlying. That is, the protective put works as an insurance.
How to implement a covered call and a protective put
Suppose we open a long position in mini futures of the E-mini SP 500. The future of the mini future of the E-mini SP 500 will be underlying that we will incorporate into the portfolio.
On the iBroker platform, we can see the price chart of the E-mini SP 500 and the volume traded. In addition, the mini SP is trading at 4080, so we assume that our long position is bought at that price. In the same broker, we go to the chain of options for the expiration of the following week.
The Covered Call and Protective Put operation have many nuances in its execution, both from the point of view of the timing and the type of strategy we want to face, so choosing more or less close strikes will depend on these conditions.
To simplify, we will choose the ones we see in the screenshot. In this case, the future mini SP executes the purchase at 4084. In the options chain, we observe strike prices of 4100 and 4055 as appropriate strikes to open the strategy. The premium for the case of the 4100 sold call is 30 (50 is the multiplier) dollars, while the premium for the 4055 bought put 33 (x50). The iBroker commission needs to be considered as it is low. With this in mind, the chart below shows the ultimate benefit of the covered call and the protective put.
Remember that both for the E-mini SP 500 futures contracts and the option premiums on said underlying, the multiplier of (x50) is applied. The covered call reduces the losses obtained in the underlying (due to the collection of the premium) in exchange for putting a ceiling on the benefits when the price of the underlying goes up, so the covered call is helpful when:
- The price of the underlying remains stable.
- We want to lock in profits when the price goes a certain way in our favor.
- We want to establish a level of profit taking extended by collecting the premium.
- And various other strategies that require a more extensive explanation.
For its part, the protective put reduces the potential benefit (due to the payment of the premium) in exchange for putting a floor on losses when the price of the underlying falls, so the protective put is used when the price is expected to fall. price of the underlying so that we deposit money for the put purchase.
We note that a complete lock in profit/loss can be done using both, as the Covered Call pays the premium price of the Protecting Put, leaving our profit/loss variance unchanged.
