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Adding Covered Calls & Naked Puts to Your Investment Strategy

Adding Covered Calls and Naked Puts to Your Investment Strategy

Options trading is considered too risky by many investors, but some strategies can increase returns without adding undue risk. Read through this article to understand a couple of popular methods.
WealthHow Staff
For those who manage their own equity portfolio, rather than relying solely on mutual funds for investment income or for retirement planning, there are some very basic strategies that may add to returns without substantially increasing risk. Now, for the most part, financial pundits will warn novice investors about the dangers associated with this form of trading. In one sense, these warnings are well-meant, as improper strategies can lead to financial ruin. However, there are a handful of very basic techniques that are easy to comprehend, execute, and no more risky than investing in equities themselves.

Basic Concept

For those entirely unfamiliar with options, they are simply a contract that obligates the seller-also referred to as the 'writer'-to sell shares of a given stock at a mentioned price. Conversely, purchasing an option provides the buyer the right, but not the obligation, to purchase shares at a given price. They always have an expiry date, at which point the contract is no longer in effect and at which time no further obligation or right exists. Additionally these 'contracts,' which are technically what is purchased or sold in a trade, are for 100 shares of a given stock, thus, allowing the purchaser to 'control' those number of shares.

'Call' options entitle the buyer to buy, or 'call away,' shares from the writer, while 'put' options entitle the buyer to sell, or 'put to,' the writer. It must be clarified that the market matches buyers and sellers-there is no predetermined individual on the other side of the trade.

Let's look at an example: If shares of IBM are trading for USD 125 per share in July, a USD 130 call (this being referred to as the 'strike price') with an expiration in August may be priced at USD 0.95. In this instance, the cost of a single contract would be USD 95 (USD 0.95 x 100). The purchase will provide the buyer the right to buy 100 IBM shares for USD 130 per share up to the expiration date. The buyer will 'exercise' this option, typically at or near expiration date, if the shares go above USD 130. Note that because these instruments are traded on the major exchanges, the owner of a contract always has the ability to sell it as well, and this happens far more frequently than actually exercising.

Put options also work in a similar manner, only reversed. Purchasing this contract on those same IBM shares at a theoretical strike price of USD 120 would allow the buyer to sell 100 shares of IBM at USD 120. If the price of IBM goes below this level, the buyer can still sell the shares at the strike price of USD 120. The difference between the market price and strike price represents the buyer's gain.

Now that we have the basics understood, let's take a look at two strategies that can help the average investor add to his portfolio's net gain.

Covered Calls

Call options are said to be 'covered' when the writer owns the underlying shares. For example, the writer owns 100 shares of IBM and would write a call contract for an immediate USD 95 gain. If the price of IBM reaches the strike price of USD 130, the writer will have his or her shares 'called away.' Note, however, that the transaction will actually result in a gain on the stock sale as well, assuming that the shares were purchased for less than the USD 130 strike price. If the expiration date of the contract arrives without the strike price being reached, the writer simply gets the USD 95 and is free to write another option, or technically, 'roll over' the contract to the next month.

One particular strategy would be to purchase the shares at market (USD 125) and immediately write the call. The net gain on this trade would be USD 95 for the call and USD 625 for selling the shares when they are called away. Ultimately, the writer would not have been able to participate in the full upside of the shares-if they had gone significantly above USD 130-but has the immediate gain associated with writing the call. Of course, if the investor would like to continue to own those shares, he or she can simply purchase an August USD 130 call to close the position.

Naked Puts

Puts are referred to as 'naked' when the writer does not own the underlying shares with which the option is associated. While this concept frightens many investors, they can be viewed simply as an attempt to purchase a stock at a discount to the current market price.

Let's go back to the IBM example. You've done all the research on this stock and feel that it's worth every bit of its market price. You'd like to buy it at market, but instead decide to write a put. Doing so allows you to gain the USD 95 immediately. Then, if the share price of IBM drops below USD 120 (the strike price), hopefully, the shares will be 'put to' you. Now, you own shares of IBM at USD 120 even though you considered it to be worth USD 125. You also have the gain of USD 95 we talked about earlier.

It is important to note that some who venture into put writing will tend to chase the highest premium. That means, they will search for stocks that offer the maximum returns for writing a put contract and act accordingly. In the safer method of writing naked puts, however, the writer should have no aversion, whatsoever, to purchasing the underlying shares and, in fact, should be pleased to have acquired the shares at a price less than the shares' perceived value.

Disclaimer: This article is for reference purposes only and does not directly recommend any specific investment choices.