In this post I will discuss two hedging strategies in futures and options trading: Covered Call and Covered Put. Some variations of the covered call and put strategy will also be discussed. If you are new to Stock Options trading and futures trading you might want to first read my posts on
- Stock Options trading explained: Call and Put Option examples
- Understanding Stock Futures Trading with a simple example.
- Buy the underlying , i.e. a stock, commodity or a Futures Contract.
- Sell or Write a out of the money Call option for the same underlying, i.e. write a call at a strike price slightly higher than the price of the underlying.
- You gains or profit increase as the price of the stock rises until the strike price of the call option that you have sold, i.e. $21. Beyond $21 you do not make any additional profit because the gains in the futures contract are offset by the loss by the call option you have written. In other words the maximum profit that you will gain by writing the covered call in this case is equal to (strike price of the call option - futures price + call option premium)=$2 per share.
- Even if the price of the stock drops by a small amount, say less than $1, you do not make a loss, in fact you end up making a profit because the options premium that you recieved by writing the covered call option. Thus a small downside of the future is 'covered' by the options premium.
- You make the loss if the price of the stock drops below $19. The amount of loss you can make is not limited in the case of the covered call strategy. In principle you capital can be wiped out. Thus covered call option writing strategy is useful only when you anticipate an upward movement in the stock option price.
- By writing a covered call - you make profit if the price rises.
- Some portion of your loss is covered by the options premium that you get by selling the call option.
|Futures Options Trading Strategy||Remarks|
|Covered Put Strategy|
Sell a Futures Contract on a stock/index.
Write a Put Option on the same stock/index at a strike price below the price of the Futures contract.
|Writing Covered put is suitable when you have reasons to believe the price of the underlying is going to go down.|
|Buy a Call, Write a Call Strategy|
Exactly like the Covered Call strategy but where instead of buying a futures contract you buy a 'at the money' options contract and write a out of the money option.
|An at the money option is certainly more expensive than an out of the money option. So in this strategy, unlike the 'pure' covered call, to start with you are at a loss and in order to make profit the price of the underlying MUST rise. However as opposed to covered call strategy there is limited 'downside loss'.|
|Covered Call + Buy a Put Option Strategy|
You use the options premium obtained by selling the covered call to buy a out of the money put option.
|This variation of the covered call strategy is suitable when you have strong reasons to believe that the price of the underlying will rise but also know that if something goes wrong then it will go wrong by a big margin, i.e. you dont want to take unlimited risk but you cover the downside risk of your futures contract by buying a put option.|
Similarly the last two strategies mentioned above have an obvious analogue for the put option.
Stock Market Derivatives: Futures, Options
Options Trading Basics
In the Money Stock Options
At the Money Stock Options
Out of the Money Stock Options