Covered Call or Protected Put?

Everyone has a preference -- and for my money, I prefer to insure with puts

   

After trading in the market for decades, I cannot think of a more commonly asked question amongst traders. You definitely can’t have it both ways and I laugh at the arguments: do you want protection with a credit or are you willing to pay for protection? I’ll let the numbers do the talking, and I am going to let you decide which works best for you. In all reality it is a matter of risk tolerance, but you’ll know which side of the fence I sit on.

Covered Calls Not All They’re Cracked Up to Be

People say that the covered call is the only way to go all the time. It is usually followed by comments like, “Don’t you want to get paid to play?” “I like credit spreads,” or “I want to take in a credit to pay for my protection.” I am going to create a quick fictitious example and the numbers are going to do the talking.

I buy to open a stock that costs me $100 a share.

I sell to open a monthly $105 strike call for $3.00-per-share credit.

Net cost basis is $100 stock price minus a $3 a share credit, which comes to $97 per share.

I now have a lower cost basis as I enter the trade. I pay $97 instead of $100 per share. I have a 3% downside protection but, I am obligated to sell my stock at $105 a share. I cap my profit for the 3% downside protection. It gives me a little downside risk to sell out of the position or get stopped out if I use a stop loss. In an ideal situation, I keep the credit and the stock moves up but doesn’t quite hit the $105 price. That would be the best of both worlds: keeping the credit when the option expires and having stock appreciation.

My risk is $97 a share or 97% of the total capital invested even if I never plan to lose that much. Also, I run the risk of a stop loss falling through and maybe being triggered at a much lower price than $97 a share. The stop loss can be triggered at the market open and  it might get triggered at a much lower price than you expect. Having 97% of my total invested capital at risk isn’t what I consider “protection.” What do you think?

I Prefer the Protective Put

On the other hand, a protective put is one of my favorite trades. It is a debit trade, so I pay to play in the trade. I am buying the right to sell my stock at a certain price for a certain period of time. “Buying insurance on stock” would be the simplest way to explain it. Let’s look at these numbers:

I buy to open a stock that costs me $100 a share.

I buy to open a $100 strike put for $7.00 a share debit.

Net cost basis is $100 stock price plus a $7 a share debit equals $107 per share.

I now have a higher cost basis as I enter the trade. I pay $107 dollars instead of $100 per share of stock or $97 like the covered call. The good news is that I have a 7% total risk in the trade with downside protection all the way down to zero. I have the right to sell my stock at $100 a share where I bought the shares. I have NO cap to the potential upside movement on the stock, but I need the stock to move at least 7% pay for the protection. It gives me a fixed downside risk no matter how far down the stock may trade. In an ideal situation stock goes through an earnings event and shoots to the moon.

Which is best? It all depends on your risk tolerance. Can you handle 3% protection or do you want 93% protection? Are you willing to spend money to make money or do you want a credit? How well do you know your stock and are you able to handle the unexpected?

Each to his own, but the numbers speak volumes to me. I prefer to trade with as little risk as possible. I am not in the market to take unnecessary risk, but to make a boring, but consistent return in bullish markets. I must say I like making up downside bearish movement with a put option acting like insurance on my stock. Why? If I am in my stock positions I never miss upside movement on my stock!

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Article printed from InvestorPlace Media, http://investorplace.com/247trader/covered-call-or-protected-put/.

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