Equity options have become integral tools for enhancing or managing the risk profiles of equity positions. Among the various strategies available, the covered call vs protective put are both significant for investors seeking to optimize their returns while effectively managing risks. Each strategy serves distinct purposes and caters to different market perspectives and investment objectives.
The covered call is favored by investors looking to generate additional income from their stock holdings through premium earnings, effectively providing a potential income stream in stable or slightly bullish markets.
On the other hand, a protective put is akin to an insurance policy against significant downturns, allowing investors to maintain their stock positions while protecting against substantial losses.
Exploring these strategies reveals how they can diversify your investment approach and protect your portfolio against market fluctuations. As I dive deeper into this issue, I’ll examine how each method can be tailored to fit individual investment goals, whether you’re looking to capitalize on premiums with covered calls or seeking downside protection with protective puts.
Understanding these options will help you decide the best approach to align with your financial aspirations. If you like learning through videos, check out this useful resource that gets into covered calls versus protective puts:
Covered Call vs Protective Put
| Protective Put | Covered Call | |
| Strategy Type | Buys put options as a hedge against stocks owned. | Sells call options against stocks held. |
| Financial Impact | Requires payment of a premium. | Generates income through premiums. |
| Market Condition | Used during expected stock downturns. | Suitable in neutral to bullish market conditions. |
| Complexity | Simpler in nature. | Considered more complex. |
| Alternate Names | Also known as married put or synthetic call. | Also referred to as “buy-write”. |
| Objective | Aims to minimize losses on stock positions. | Seeks to produce extra income from stock holdings. |
| Profit Limitation | Does not cap upside if stock price increases. | Caps gains, limiting profit potential. |
What is a Covered Call?
A covered call is like setting up a safety net for your stock investments while also squeezing out some extra cash. Imagine you own shares in a company and you think the stock’s price is going to stay about the same or climb just a little. By selling a call option on those shares, you collect a fee called a premium right away.
Here’s the deal: if the stock price doesn’t go higher than the price set in the option (that’s the strike price) by the time the option expires, the option is worthless and you get to keep that premium—sweet, right? But if the stock price shoots above the strike price, you might have to sell your shares at that price, missing out on any extra profits if the stock keeps rising.
So while you’re getting some cash upfront and a bit of a buffer if the stock price dips, you’re also capping how much you could earn in a boom. It’s a trade-off, giving up unlimited upside for immediate cash and some protection on the downside.
Check out my writing covered calls strategy article for a deep dive into the topic.
What is a Protective Put?
A protective put is like buying an insurance policy for your stock portfolio to shield it from sudden market downturns. Let’s say you own some stock, and while you’re optimistic about its long-term growth, you’re a bit jittery about possible short-term losses, maybe there’s an unpredictable earnings report coming up or some economic turbulence on the horizon.
By purchasing a put option, you essentially buy the right, but not the obligation, to sell your stock at a predetermined price, known as the strike price. This strategy puts a floor on your potential losses. If the stock’s price tanks below the strike price, you can exercise your option to sell at the higher strike price, dodging a financial bullet.
However, if the stock’s price goes up, you’re still in a position to gain from those rises, minus the cost of the put option you bought.
So, while it does cost you some money upfront in the form of a premium, think of it as paying for peace of mind. You’re ensuring that no matter how the market swings, you won’t lose more than a certain amount, while still having the opportunity to benefit if the stock’s price climbs.
Consider my protective put strategy article for a detailed dive.
Covered Call Best And Worst Case Scenarios
In the world of covered calls, you’re balancing potential profit against limiting possible losses, all while earning a bit of extra cash. Let’s break down the scenarios of maximum profit and maximum loss with this strategy, including the simple profit equation that can guide your expectations.
Covered Call Maximum Profit Scenario
The best-case scenario with a covered call happens when the stock price rises to or just above the strike price of the call option at expiration. Here, you rake in the maximum gain from the stock’s price increase up to the strike price, plus you pocket the premium from selling the call option.
The covered call formula, it looks like this:
Profit=(Strike Price−Purchase Price)+Option Premium
Covered Call Maximum Loss Scenario
The worst-case scenario occurs if the stock price plummets to zero. While it’s a grim prospect, the premium you received provides a slight cushion. Here, your losses are offset by the premium from the option, but essentially, your maximum loss is the entire value of the stock minus the premium received.
In simple terms, if you bought a stock at $50, sold a call option with a $2 premium, and the stock went bust, your net loss would be $48 per share. You lose the initial $50 but remember, you keep that $2 premium no matter what.
This setup of covered calls is great for those who seek additional income from their stock holdings and are comfortable capping their upside to protect against significant downturns.
Protective Put Best And Worst Case Scenarios
Protective puts can seem like having a financial safety net while you’re aiming for the stars with your stock investments. Here’s how it plays out in terms of your best-case gains and worst-case losses, complete with the equations to help you measure your potential outcomes.
Protective Put Maximum Profit Scenario
The sky’s the limit when it comes to the maximum profit in a protective put scenario. This is because if the stock price shoots through the roof, your profit potential is unlimited. The put option acts as your insurance policy, so while you do pay a premium for it, it doesn’t cap your earnings from the stock itself.
The formula to determine your maximum profit is straightforward because your profit potential continues as long as the stock price climbs. However, you must subtract the premium you paid for the put option:
Profit= Sale Price−Purchase Price−Option Premium
If you have a good broker like TradeStation, you don’t have to worry about calculating the profit yourself. Check out my TradeStation review to see why it is the preferred broker for many successful options traders.
Protective Put Maximum Loss Scenario
On the flip side, your downside is significantly restricted with a protective put. The most you can lose is the difference between what you paid for the stock and the strike price of the put option, plus the premium you paid for the option itself.
This gives you a firm safety net. The loss is capped and can be calculated as:
Maximum Loss=(Purchase Price−Strike Price)+Option Premium
For example, if you buy a stock at $100, purchase a put option with a strike price of $90 for a premium of $5, your maximum risk is $15 per share. This calculation comes from the $10 you could lose on the stock (from $100 down to $90) plus the $5 premium for the put option.
Using protective puts, you effectively manage your risk by defining the floor for potential losses while keeping the ceiling open for possible gains. It’s a strategy that allows investors to pursue growth with a defined safety buffer, blending cautious optimism with strategic defense against stock downturns.
Covered Call vs Protective Put: My Final Thoughts
When you’re weighing the options between a covered call vs protective put, you’re basically looking at two different ways to handle your investments, depending on how the market’s doing and what you expect to happen.
If you feel like the market’s going to be fairly steady or might grow a bit, a covered call could be a great choice. It lets you earn some extra cash from premiums while giving you a bit of a buffer if prices dip slightly.
Now, if you’re a bit uneasy about potential market drops or you expect some turbulence ahead, then a protective put might be more your speed. It’s like having an insurance policy on your stocks. You won’t lose out on the chance to benefit if stock prices soar, but you’ll have peace of mind knowing you’re protected against a crash.
Both strategies have their perks, and it really comes down to what you’re comfortable with and what you’re hoping to achieve. Are you looking to rake in some regular income from premiums, or are you more about guarding your investments against the unknown? Either way, getting a handle on these strategies can really help steer your portfolio through whatever the market throws your way.
To learn more about other strategies, check out my low risk option strategies article. Happy Trading!