Protective puts, covered calls, rolling options – HUH?

Yesterday, I went for a free value investing workshop with a friend of mine just to see what it would be about. I have been to lots of free previews and workshop and actually one can learn a lot from these free workshops. Yesterday, too, I learnt a few new stuff after the workshop.

The workshop touched on value investing strategies by Warren Buffett and another strategy on trading options with the value investing strategy. It was a very interesting eye-opener for me. I knew options exists and they can be very versatile at times to hedge on your positions. I have done some research on it myself and have paper traded it before. However, I just knew yesterday that you can incorporate value investing and options to mitigate risks and also make monthly consistent profits. I know it sounds too-good-to-be-true and that was how I felt when I heard it at the workshop. So this morning, I went to google on the strategy (the strategy or its name wasn’t revealed fully but I kind of knew how it works) and by using my ever-reliant spidey senses, came across the actual name of the strategies and found some interesting websites on it as well.

The strategies are called ‘selling puts’ and ‘covered calls’. There are other strategies to hedge your positions using ‘protective puts’ and ‘rolling options’.

Selling put is done when you believe the stock will be bullish and the company is fundamentally strong. So, you write a put and sell it to a buyer while you collect the option premium. If the option expires worthless, then you keep the premium. If the option becomes in-the-money, you are willing to buy the stock anyway since it is a good business and you want the stock at the said price (intrinsic value). For example, let’s say I want to buy Nike at $50 (its intrinsic value) but the stock is now trading at $75.55. I don’t want to buy it at $75.55 as it’s too expensive. So, I write a put option at $50 strike price and collect premium for it. If the stock continues on a uptrend, then the option will expire worthless and I keep the premium. If the stock reverses downwards towards $50, then the option will become in-the-money and I have the obligation to buy it at $50. It doesn’t bother me as Nike is a fundamentally good company and I wouldn’t mind holding it anyway (you can do a ‘covered call’ now since you own the stock. Covered call is discussed below). Why would the buyer want to buy a put from me? To protect himself from downside risks. I’m just like an insurance underwriter and the buyer is paying a premium to me to protect him (his stock for this case) and this is called buying a ‘protective put’ in the buyer’s point-of-view. This is how ‘selling put’ works. And it can be done monthly. Click on Selling puts to learn more.

Next is selling a covered call. You do a covered call when you believe the stock will move sideways or downwards in the near term but are bullish in the long-term (useful for a value investor just like selling puts). Before, you do a covered call you need to physically hold shares of it (that’s how covered call got its name). It’s the opposite of selling naked call where you don’t hold shares of the stock and this exposes you to unlimited risk! When you own stocks of a company, you can sell covered calls and make money through the options premium. You sell the call at a strike price higher than the stock price and hope stock price will never hit the strike price. If it does, the option becomes in-the-money and you have an obligation to sell the stock to the buyer.  So, this strategy is used only on stocks that you are neutral on in the short-term. Also, choose a stock that will give you monthly dividends. So, on top of receiving premiums, you also receive dividends. This can give you monthly income from the dividends and premium.  This is sometimes called the ‘stock rental strategy’. Click on Covered Call to learn more.

So, you can combine selling puts and doing covered calls in a single strategy as seen above. This provides another weapon in the value investor’s toolbox instead of just waiting for dividends or capital gains.

Warning: Before diving into options trading, research thoroughly first and learn fully. Try paper trading to get a hang of it. Options trading is risky for the uninitiated!

Author: Sudhan P

I simplify investing concepts to help you navigate the stock market jungle. View all posts by Sudhan P