Option Strategies – Covered Call and Married Put
One of the most intriguing things about options trading is the variety of choices available to the educated trader. With dozens of option strategies available, competent traders can analyze the market conditions, their personal risk tolerance, and their financial objectives, and then choose the option strategy that best fits all criteria. Some traders find specific option strategies that work best for them, and others utilize numerous strategies depending on the market situation they encounter.
The key for any option strategy is to know the market conditions that need to be present to use the strategy, how to execute the strategy, and whether the strategy fits within their risk parameters. There will always be a little terminology to learn with any strategy, but once you get the basics down, you will discover the terminology becomes easier and easier with each strategy that you learn.
Covered Call
One of the primary reasons that traders utilize covered calls is to generate cash flow. Covered calls are also utilized to offer some downside protection, and can be used to grow your portfolio. This can be done using stocks that you already own or stocks that you buy with the specific intention of writing calls against them. Covered calls are one of the first strategies that many investors learn, and are extremely popular among traders who wish to generate cash flow from the markets, but don’t have time to manage their trades during market hours.
Steps for Executing Covered Call Trades:
1) Build a watchlist of stocks with good fundamentals. The first step is to find candidates that would make good covered call trades. Because you are going to own the stock, fundamental analysis plays a large role in selecting the stock you will ultimately end up using. Good traders will build a sizeable watchlist of stocks with good fundamentals to give them multiple candidates to choose from. Good fundamentals decrease the probability of a bad news occurring, and many stock search programs can assist you in filtering out stocks with good fundamentals from stocks with average to below -average fundamentals.
2) Pick a stock in a neutral to bullish market. Some traders are fine choosing stocks with good fundamentals where the stock is in a sideways trend. They have the experience to take advantage of these trends, and will actively monitor the trade, and make adjustments if necessary. Remember, you are going to own the stock, so picking stocks in a moderate uptrend increases the chances that you are going to make a profit on the trade. Covered calls should not be utilized in volatile markets because the potential gain is minimal versus the potential downside loss that a volatile market can create.
3) Choose a strike price. There are two schools of thought in choosing a strike price. You can pick an out-of-the-money call option, or sell an in-the-money call option. While you have greater chance at assignment, selling in-the-money calls are is popular among traders who wish to protect against downside risk. A trader may have a stock in his portfolio that is experiencing selling pressure, and wishes to help protect gains he might have made up to this point. To offset the losses, he sells an in-the-money call. For every dollar lost from that point, he makes one back from the decrease of intrinsic value on the option.
Be sure to analyze the time value left in the option to help determine which option you should choose. For example, it would make no sense to sell a $35 option at 7.10 if your stock was at $42.00. There would be simply little reward.
4) Determine the month you are going to sell. As a general rule, you will want to choose the next available month. This will allow you more flexibility in managing your trade and more monthly opportunities.
5) Use technical analysis to determine entry point. Many traders time their entry into the covered call trade by using their knowledge of technical analysis. For example, let’s assume a stock is approaching a resistance point of $35. They own the stock already, and then decide to write a $35 call at resistance on a stock they wish to own long term. Another potential entry point might be if this same stock pulls back to a support level at $30. As soon as the stock demonstrates price movement upward, an astute trader might buy the stock at that point and wait to sell the call until it reaches the next resistance point, in order to capture more profit on the stock. This is known as legging in.
6) Monitor your trade. There will be times that the trend reverses, that your stock will fall through support, and you will be facing a losing situation. You need to check your stock each day at night or in the morning before the market opens, whatever your routine allows. Most days, you probably will need to do nothing. There are a few situations, however, you may need to monitor:
a. You will encounter situations where there is little time value left in the option you sold, and have captured the majority of potential gains possible. You may want to buy to close the call you originally sold.
b. If the fundamentals on a stock change, the market becomes volatile, or if support is broken on a stock, your rules may dictate that you exit the trade even though you are staring at a loss. In this situation, you would buy to close the call you originally sold and sell the stock.
c. If the call expires at expiration, you may choose to write another call on the same stock. Go through the same routine again to determine whether the stock still makes a good covered call candidate.
With covered calls, there is always the risk of being assigned (called out) on your position. Also, the stock may suddenly breakout of a resistance point, and the trader will lament that they simply didn’t hold onto the stock. Traders with experience have long accepted these situations, and don’t become overwhelmed with the what ifs of trading.
Married Put
The married put is another option strategy that is used when the trader or investor owns the underlying stock. Where covered calls are used primarily as a means to generate cash flow, married puts are used as a type of insurance policy when investors want to hold onto their stock, but are concerned about potential downside market risks. The primary benefit that investor receives is that they retain all benefits of stock ownership. They still receive any dividends, voting rights, etc.
How the Strategy Works
Let’s assume an investor has 2,000 shares of stock XYZ.
1) The investor would need to buy 20 put contracts at the strike of their choosing. The put contract guarantees a selling price of the stock.
2) The put serves as an insurance policy on the underlying stock with the insurance premium equaling the premium of the contracts.
3) The married put protects against sudden movements of the stock and situations where a stop loss might not full protect the investor.
4) The maximum profit is still unlimited.
5) The maximum loss is simply the stock purchase price minus the strike price chosen minus the premium for put contracts.
The married put is not for every trader, and may have very situational needs. For many investors, the use of a stop-loss is sufficient for their trading needs. However, if you find yourself in a situation that you wish to retain the shares of stock but want to minimize your risk, it is always good to have a variety of option strategies available to meet your particular needs.
Next month, we will continue to review different option strategies by examining the straddle and strangle.