Investing Strategy - Part IV

Covered Calls and Protective Puts

Continuing the series on Investing Strategies, today I want to take a look at the covered call and the protective put. In my earlier Investing post on options I discussed the concept of the collar. The covered call and protective put are the two components that make up the collar. So what are they, how do they work, and why are they beneficial?

The covered call is the probably the most common type of option position taken in the market. To enter a covered call position, you must buy or own 100 shares of a stock and then you sell a call option - you give someone else the right, but not the obligation to buy your stock. If the call gets exercised you get to sell your stock for the strike price you accepted when you sold the option. If the call is not exercised, you get to keep the premium the call buyer paid and you keep the stock. That's why we sometimes described it as collecting rent on the stock. Covered calls work best in generally flat markets, as you can repeatedly "collect the rent" without ever having to sell the stock.

The protective put is a way of buying term investment insurance. Again you have to own a minimum of 100 shares of the stock. For as long as you own the put, you have insurance that in the event the stock price declines significantly, you can exercise your right (but not obligation) to sell the stock at the agreed upon strike price. It essentially sets a floor on how low the stock can go for you for a set period of time. And buying a protective put is very much like buying insurance - you pay the premium for the peace of mind that having a stock price floor brings.

Put together a covered call and a protective put and you have a collar, which essentially dictates what kind of value range your position will stay in. The call prevents it from going too high; the put protects it from going too low. Usually when entering into a collar, the proceeds from the sale of the call are used to finance the purchase of the puts, which means little to no money out of pocket for the trader.

Both of the strategies are about as safe as you can get while dabbling in the options market. As such they are the only options positions that the IRS has approved for use in IRA accounts.

Hedging a position against a sideways or down market is usually one the primary goals of every long-term investor. The covered call and protective put can both be excellent tools for furthering that goal.