CFA Level 1

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Derivatives - Managing Risk with Options Strategies: Covered Calls and Protective Puts

Covered Call and Protective Put Strategies
There is one more way for options to be classified:

  • Covered
  • Uncovered, or naked

Whether a contract is covered or uncovered has a great deal to do with the margin, or credit, required of the parties involved.

Covered Call
A covered call is when the investor has a long position in an asset combined with a short position in a call option on the same underlying asset. A call writer may be required to deliver the stock if the buyer exercises his option. If the call writer has the shares on deposit with her broker, then she has written a covered call. There is no margin requirement for a covered call; this is because the underlying securities are sitting right there - there is no question of creditworthiness.

An investor will write a call option when he feels that a particular stock's price will not rise above a certain level. Note that if the call option is exercised in the money, the call writer will sell the call option holder's stock from his inventory at the strike price indicated in the option contract. His maximum loss would then be:

Maximum loss = Call Premium + Exercise Price - Price Paid for underlying asset.

Let's look at an example. Suppose that you have 250 shares of XYZ that you bought for $17 and that the XYZ Jul 20 call option trades for $1.


The following diagram illustrates the typical payoff to expect from a covered call.

Uncovered Call
If the call writer does not have the underlying shares on deposit, she has written an uncovered call, which is much riskier for the writer than a covered call. If the buyer of a call exercises the option to call, the writer will be forced to buy the asset at the spot price and, since there is no limit to how high a share price can go, that spot price can theoretically go up to an infinite amount of dollars.

Protective Put
A protective put is an option in which the writer has cash on deposit equal to the cost to purchase the shares from the holder of the put if the holder exercises his right to sell. This limits the writer's risk because money or stock is already set aside.

The risk, however, is not that great. The stock is not going to be purchased at the spot price; it is going to be purchased at the exercise price, which was agreed to the day of the opening transaction. The higher the spot price goes, the more the writer benefits because she buys the stock at the lower exercise price and sells it for whatever she can get in the market. There is a risk that the spot price will go down, but the lowest it can go is $0 and that almost never happens in the span of time covered by an options contract.

Let's consider the worst-case scenario in which the writer has to pay the full exercise price for a completely worthless stock. If she sold a put at $18 and it is now worth nothing, then she has lost $18 for each share she pledged to buy: if that was a block of 50,000 shares, the loss amounts to $900,000. Nobody wants to lose that kind of money, but it is insignificant compared to the astronomical losses possible with writing uncovered calls.

Example: Say ABC stock trades for $75 and its one-month $70 puts trade for $3. A put writer would sell the $70 puts in the market and collect the $300 [$3 x 100] premium. Such a trader expects the price of ABC to trade above $67 in the coming month, as represented below:

Thus, we see that the trader is exposed to increasing losses as the price of the stock falls below $67. For example, at a share price of $65, the put seller is still obligated to buy shares of ABC at the strike price of $70.

He or she would face a loss of $200, which is calculated as the following:

$6,500 (market value) - $7,000 (price paid) + $300 (premium collected)

Uncovered Put
The difference in the risk profiles between uncovered calls (nearly limitless risk) and an uncovered put (clearly defined risk) is why conservative investors who would never think of writing an uncovered call will not hesitate to write an uncovered put. An uncovered put is a short position in which the writer does not have cash on deposit equal to the cost to purchase the shares from the holder of the put if the holder exercises his right to sell. Again, the writer knows, to the dollar, exactly what the worst-case scenario is and can make an informed decision about whether or not it is worth tying up capital to cover the put.

CONCLUSION
Within this section, we've learned about derivatives, forwards, futures, options and swap markets, the characteristics of the various types of derivatives, determining payoffs of various strategies and positions, and how to apply option strategies to manage risk.

Introduction
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