November 21, 2018

A Useful Tool For Your Options Playbook

Many traders are familiar with the concept of the covered call strategy.  Few know what it really means though.

The concept is quite simple.  You own stock.  You then sell a call with a strike price above where the stock is currently trading.

What you have essentially done is taken a long equity position and created a “synthetic put” position from that.  The formula is quite simple:

Call + Strike = Put + Stock Price

Here are the three graphs.

Long underlying stock:

Short call:

The combination of the two looks exactly like a long put:

This strategy achieves a couple of things.  You give yourself a bit of downside protection.  Specifically, the premium you collect lowers the cost basis you paid to get into the stock.  If I buy 100 shares of Facebook at $137 and I sell a December 150 call for $1.00, I am effectively long FB for $136.

If FB rallies to $150 at expiration, that is great!  I am still long the underlying from $136 and my calls that I sold are still worthless!  I make $14 in my underlying stock position and the options go out at zero!

If FB goes down in price, then at least I have mitigated a portion of my loss.

If FB rallies hard, well then I left money on the table.

Let’s say FB rallies to $170 by expiration.  My underlying position is doing just fine.  I am long from $136 and it’s trading $170.  A gain of $24! But whoever bought the 150 calls from me is going to exercise their right to get long FB at $150.  I have capped out my gain. I will then deliver to them the stock I already own.

Still a good story overall, but hindsight is always 20/20.

Happy Thanksgiving to all!

about the author:

Mike Shorr

Since 1994, Michael has been an on-the-floor market maker, Vice-President of Interest Rate Derivatives for Knight Financial Products and Director of Education and Options Instructor at Trading Advantage. He makes the oftentimes complex world of options and trading accessible to the novice and advanced trader alike. Michael has a Bachelor of Science degree in Statistics and Finance from the University of Illinois Champaign-Urbana. He presently is Director, Trader Education at ProsperTradingAcademy.

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