Covered positions

Covered option positions are those where you actually own the underlying shares before selling an options contract. This ensures that, should you be assigned, you already own the shares you will be required to

Covered calls

A covered call is a position where you sell a call option against a stock you already own. Owning shares at the time the option is sold allows you to limit your loss in the case the stock rises above the strike price before expiration. That is,

• If the stock price surpasses the strike price, you will be on the hook to sell 100x shares to the buyer of the call for the strike price. Doing this will wipe out any gains you made from holding the stock above the strike, but you will profit from gains made from the stock price at the time of selling the call and the strike. You will also keep your premium. This is the primary situation that covered calls help to protect you against; owning the 100x shares when you find yourself assigned high above the strike is no big deal.
• If the stock rises but doesn’t reach the strike, you will keep your shares, along with the premium from selling the call. After expiration you dump the responsibility to sell shares, and you will keep your 100x shares along with the gains they made from the time of selling the call.
• If the stock falls below the price at the time of selling the call, your option will of course not be executed, but you will lose on holding the underlying shares. The premium obtained from the contract can help offset this, but you now take on the downside risk of holding the stock just like a regular position.

The main benefit here is to shift risk from the potentially unbounded losses of naked calls, to the standard unbounded losses of simply holding shares. A covered call can be a great position if you believe the price of a stock is going up, wanted to hold shares anyway, but also have a strong hypothesis about a cap on how high that stock price will rise in a given time period. In this case, you can own your shares like you intended, sell a call option against those shares just above your hypothesized cap, and bank some extra premium. Of course, compared to naked calls, you have actually fork over the capital to purchase the shares, so less can be spent on options contracts themselves.

In summary, the covered call is a less risky call option. When selling a naked call, you have a capped gain of $P$, and an unlimited potential loss of $(E-S)-P$ (since $E$ has no bounds). The covered call balances this lopsided risk by increasing (capped) gains to $P+(S-C)$, and the unlimited potential loss now comes from owning the shares when the price drops, or $(C-E)-P$ (note that owning shares also has unlimited potential loss, but is de-emphasized due to its relative tameness compared with the scale potential of options).

Cash covered puts (cash secured puts)

Note these are not “covered puts”, a slightly different term.

A cash covered put is an options position where you sell a put option while having the funds to cover assignment without dipping into margin. That is, you are essentially willing to hold 100x shares of a given stock at a certain price, but you elect to sell a put at that price, raise some premium (to lower your basis or enable larger investment), and take on a little extra risk of holding the stock at the strike price while its market price is lower. This latter point is the reason you receive the premium.

This can play out in a few ways:

1. If the stock price is not below the strike by expiration, you simply keep the premium without having to open a position and purchase 100 shares.
2. If the stock price is below the strike by expiration, you will still have your premium but you will be responsible for purchasing 100 shares at the strike price. You now have opened a position (with 100 shares) at the price you were willing to buy the stock beforehand (with the possibility that the market value may have dipped below this level at this point).

Put credit spread (bull put spread)

1. Sell put and collect premium
2. Buy cheaper put with lower strike (with premium money)

So you hold premium and a put, with your account credited the difference in premium between the puts. Here you’re collecting premium on a relatively more risky put (i.e. it’s not as far out of the money) than the one you buy (costing a lower premium as it’s further out of the money).

But what’s the point? Limit downside risk. Selling puts of course has unbounded downside potential (responsible for difference between stock price at execution and strike price if that price is below the strike). The put credit spread has the following possible outcomes:

1. The stock price rises above the original put’s strike price. In this case you will not be assigned, and you will bank the difference in premium you originally collected (since your cover put also expires worthless).
2. The stock price falls below the original put’s strike, but above the cover put’s strike. In this case you will be assigned, and responsible for the difference in the strike price and the price of the stock at expiration. There is some room for the premium to cover this until the break-even point, after which you will have traded for a loss.
3. The stock price falls below both puts’ strikes. In this case you will realize your max loss, which is the difference between your strike prices times 100 times the number of contracts. The cover put places a lower bound on how much you can lose by always ensuring you can sell the shares (for lower) you must buy (for higher) with the original put. This is better than having to potentially sell for much, much lower.

All in all, this is a bullish strategy with limited downside risk. Like a naked put, you want the stock to go up (or at least stay above the strike) so you are not assigned and bank your premium. However, you sacrifice a portion of this premium in a put credit spread to ensure you can only lose some predetermined, fixed amount, decided by strike price of the “cover put”(or at least stay above the strike) so you are not assigned and bank your premium. However, you sacrifice a portion of this premium in a put credit spread to ensure you can only lose some predetermined, fixed amount, decided by strike price of the “cover put” sold at a lower strike. It essentially a less risky way to take a bullish stance by selling puts (i.e. you should prefer this to selling naked puts when you are more risk-averse).

Call credit spread (bear call spread)

• Bearish strategy
• Limits losses in unfavorable outcomes
• Lower risk than naked calls
• Hedges covered calls against price increases

1. Sell call and collect premium
2. Buy cheaper call with higher strike (with premium money)

Just like with the put credit spread, we are holding some premium and a call, with our account being credited the different in premium between the call option prices. The call with a higher strike price is further OTM and thus will always cost less, so this different will be positive.

The point of this spread is, like the put credit spread, limit downside risk. Selling naked calls is very risky, with limited upside (the premium) and unbounded downside risk (since the stock can rise as much as it likes). Holding a call at a higher strike enables us to purchase 100x shares at this bounded upper strike to sell to the buyer of our lower call.