Selling covered calls against a long stock or ETF position is a great way to hedge risk and smooth volatility.
For example, selling a covered call on the S&P 500 (SPX) on a monthly basis has shown to not only reduce volatility, but to increase returns over the long term.
However, considering the current market conditions, many investors are looking for even more protection against market downturns.
Trading a covered call/protective put combination can be a great way to harvest many of the benefits of a covered call while maintaining fixed risk to the downside. This strategy combines two of the most common uses for options; both of which are focused on protecting against losses while still providing the opportunity for profits.
The strategy is relatively simple. In the accompanying video, I will walk through a case study using the iShares Russell 2000 Index (IWM) by selling an at-the-money call against a long position in this ETF (the covered call) and buying an out-of-the-money put (the protective put) to limit losses.
The short call will provide a premium for potential profits and the protective put limits the risk in the position.
In the example in the video, the prices I use are as follows.
IWM April 41 Call: $2.22 — premium received
IWM April 39 Put: $1.10 — price paid
The long put has reduced the premium received from the call to $1.12 per share ($2.22 – $1.10 = $1.12), or $112 per contract. The offsetting benefit of this reduction is that there is now a maximum loss of $1.27 per share no matter how far the stock drops.
For this case study, imagine three potential outcomes at expiration in April:
1. The stock rises to $43 per share.
The stock will be “called out” at $41, creating a 37-cent loss offset by the $1.12 per share net option premium for a gain of 73 cents per share, or 2%. This is the maximum gain that month.
2. The stock stays flat at $41.39 per share.
The stock will still be called out at $41, creating a 37-cent loss offset by the $1.12 per share net option premium for a gain of 73 cents per share or 2%. This is the maximum gain for April, and the results look identical to the first scenario.
3. The stock falls to $35 per share.
The stock falls to $35, creating a loss of $6.39 per share, which is offset by the put (which is now worth $4) and the net option premium of $1.12 per share. This has limited the actual loss to $1.27, which is the maximum possible loss that month. The benefit of this strategy is that losses won’t exceed the maximum of $1.27 if the market moves against your forecast.
Keep in mind that in any of the three potential outcomes you can re-enter the trade the next month and every month after that should you choose to do so. As market events unfold, you may choose to loosen the risk control to allow for more upside potential. This kind of strategy is extremely flexible and allows you to adjust it for your own risk tolerance.