This article originally appeared on The Options Insider Web site.
Risk management is key to a trader’s survival.
It has often been said that those who survive are not the ones who make the most money, but the ones who lose the least. Even the best traders make bad trades, and minimizing losses is one of the most important things you can do to help ensure that you’ll survive to trade another day.
In volatile markets, this is more important than ever. That’s why I’d like to focus on a few ways you can use options to reduce or limit your risk.
The notion that options are only for speculators, and are either too risky or too complicated for average investors, is a common misunderstanding. Although it’s true that options can be used for speculating, they are often used to hedge equity positions and help minimize the risks of trading.
And while there are a lot of complex option strategies, many are simple and can be effectively used by investors who have rarely or never traded options before.
Among these simpler strategies are covered calls and covered puts. Employed correctly, these strategies can potentially increase profits and limit losses simultaneously.
Covered Calls: Long Stock Position and Short Calls in Equal Quantity
This is one of the most common option strategies. Selling covered calls against an equity position generates premium income and creates an obligation to sell the stock at the strike price.
While covered calls can be a great way to generate income in a flat or mildly uptrending market, the limited risk protection that covered calls can create should not be overlooked. The protection is limited to the amount of premium received.
A covered call writer typically has a neutral to slightly bullish view of a stock. In many cases, the best time to sell covered calls is either at the time a long equity position is established (buy/write), or once the equity position has begun to move in your favor.
When creating a covered call position, it’s generally best to sell options with a strike price equal to or greater than the price you paid for the equity. If the stock remains flat, declines in value or even increases a little, an at-the-money or out-of-the-money call will likely expire worthless and you’ll get to keep the premium you received when you sold the covered calls, with no further obligation.
Once that happens, you can do it all over again for another month. If, by the expiration of the option, the stock has appreciated in value to slightly above the strike price, you’ll probably have your stock called away at the strike price. This could occur prior to or at expiration.
This isn’t necessarily a bad thing, though. If you sold at-the-money or out-of-the-money calls, this will generally result in a profit on the trade. That profit will usually exceed the profit you would have made had you simply bought the stock and then sold it at the appreciated price.
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Here’s an example of this strategy:
Let’s assume that you buy 1,000 shares of XYZ stock at $72, and sell 10 XYZ April 75 Calls at $2. Remember that one option contract represents 100 shares of the underlying stock, so 10 contracts would cover your 1,000-share position.
Because you bring in two points (dollars) for the covered call, it provides two points of immediate downside protection. In other words, you will not have a loss unless the stock drops below $70.
As you know, there’s always a downside, and in this example, the trade-off is that we limit the upside profit potential beyond a price of $77 ($75 strike price + $2 premium). You would only want to do this if you thought the price of XYZ would not exceed $77 by the April expiration. If XYZ did increase above $77, the stock purchase alone would have been more profitable.
If we put this combined trade example on a graph, you can see that the breakeven price is $70, and the profit is capped at $5,000 for all prices beyond $75 ($3 x 1,000 [shares of stock] + $2 x 10 [option contracts] x 100 [options multiplier]).
You can also see that even though the stock can drop two points before you go into the red, losses will be incurred below $70, all the way down to a price of zero. The losses will always be $2,000 less than the stock trade alone, but could be as much as $70,000 if the stock drops to zero (compared to $72,000 if you had simply bought the stock).
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Covered Puts: Short Stock, Short Puts in Equal Quantity
Covered puts work essentially the same way as covered calls, except that the underlying equity position is a short stock position instead of a long stock position, and the option sold is a put rather than a call. A covered put writer typically has a neutral to slightly bearish sentiment.
Selling covered puts against a short equity position creates an obligation to buy the stock back at the strike price of the put option.
Just like with covered calls, often the best time to sell covered puts is either at the same time a short equity position is established (sell/write), or once the short equity position has begun to move in your favor.
Since the concept is similar to a covered call, we’ll jump straight to an example:
Below is a graph showing a hypothetical covered put trade in which you sell short 1,000 shares of XYZ at $72, and sell 10 XYZ April 70 Puts at $2.
If we put this combined trade example on a graph, you can see that the breakeven price is $74, and the profit is capped at $4,000 for all prices below $70 ($2 x 1,000 [shares stock] + $2 x 10 [option contracts] x 100 [options multiplier]).
You can also see that even though there are two points of price protection against an increase in the stock price, losses will be incurred above $74, all the way up indefinitely. The losses could be unlimited if the stock continues to increase. In each case though, the losses would always be $2,000 less than the stock trade alone.
You would want to employ this strategy only if you thought the price of XYZ would not fall below $70 by the April expiration. If XYZ did fall below $70, the short stock trade alone would have been more profitable.
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A Few Words of Caution
As you know, there are very few risk-free profit opportunities in trading — and covered calls and covered puts are no exception — so, I’ll conclude with a few precautionary points:
1) These strategies will usually limit significant profit potential if a stock moves substantially in your favor.
2) While these strategies do limit risk somewhat, they cannot eliminate it entirely.
3) Losses are limited only by the amount of premium you receive on the initial sale of the option.
4) Any time you sell a covered option, you have established a minimum buying price (covered put) or maximum selling price (covered call) for your stock. Any movement in the stock beyond that established price creates no additional profit for you.
5) Selling a covered option when your stock position has already moved significantly against you could cause you to establish a closing price that ensures a loss to you.
6) To make sure that you don’t lock in a losing trade, before you sell a covered call or put, ask yourself, “Would I be happy if I had to close out my stock position at the strike price on this option?” If the answer is yes, you’ll probably be OK.
7) While our examples assume that you hold the covered position until expiration, you can usually close out a covered option at any time by buying it to close at the current market price.
8) Whether the equity portion of your strategy is profitable or not, waiting until expiration will maximize your return on an out-of-the-money option — however, you are not required to do so. In addition, a significant change in the price of the underlying stock prior to expiration could result in an early assignment.
9) Keep in mind that if your short option is in-the-money, you could be assigned at any time.
10) Be very careful before you decide to sell a covered option that’s been adjusted due to a company reorganization.
11) When companies merge, spin off, split, pay special dividends, etc., the options of that company can become very complicated.
12) If you see a deal that seems too good to be true, it probably is.
Remember, you win some and you lose some — you can’t be right all the time. The important thing is to survive the losers and make it to the next winner.
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