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Using Covered Calls and Puts to Gain Trade Management Flexibility

June 2, 2011 by Nick Metzger| Tips & Strategies

What is a Covered Call or Covered Put?

A covered call/put is an option strategy used by traders who hold a long/short futures position and sell a call/put option on the same underlying futures.  If the trader is long the futures contract, the trader will sell an out of the money call.  If the trader is short the futures contract, the trader will sell an out of the money put.

Why Do Traders Use This Strategy?

This strategy provides traders with an opportunity to earn additional income when the market consolidates and provides some extra cushion if the underlying futures moves against them.  Under most circumstances, the strategy will be used when a trader has a directional opinion of the market.  The idea behind the strategy is to take a directional position on the futures and sell an option that is out of the money to a level they feel the market will have a difficult time reaching.  This allows the trader to hold their long or short position as well as take advantage of the options time decay.

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Covered Call Example

Bob feels that the price of corn will increase over the next few months.  Currently corn is trading at $7.00 per bushel.  Bob buys one futures contract at $7.00.  Bob feels demand for corn is very strong at $7.00, but feels that this strong demand will begin to ration if/ when the price exceeds $8.00.  Based on this assumption, Bob decides to sell an $8.00 call option.  By selling the $8.00 call, Bob collects 25 cents ($1,250).  The sale of the option provides Bob with a 25-cent cushion in case of an adverse move in corn.  This will give Bob a breakeven price of $6.75 on his futures contract ($7.00-$0.25= $6.75).  If the market sells off beyond $6.75, Bob will be at a loss on the trade.  If the market moves higher, Bob will be at a profit but will be limited to a max profit of $1.00 ($8.00-$7.00).

Trade Management Flexibility

This strategy provides Bob with some flexibility on how he manages the trade.  If the market sells off, Bob can roll down his $8.00 call option to a call at a lower strike price.  This would allow Bob to collect additional premium and lower his breakeven.  For example, let’s say corn sells off by 40 cents and is now trading at $6.60.  The delta on Bob’s $8.00 call is 0.25, which means that his option will decrease at a rate of 0.25 for every 1.00 point move in the futures.  So if corn were to sell off 40 cents, Bob’s call option would drop in value by about 10 cents (40*.25= 10).  You can learn more about an option’s delta by reading my article “Going Greek: Understanding Your Option’s Delta”.  In this example, Bob will buy back his $8.00 call at 15 cents locking in a profit of 10 cents on the trade (25-15=10).  Bob can then sell a $7.75 call and collect an additional 20 cents.  Between the profit taken on the sale of his $8.00 call (10 cents) and the additional premium collected from the sale of his $7.75 call (20 cents), Bob’s new breakeven on the futures is $6.70 ($7.00-0.30= $6.70).  This will also reduce the max profit on his position to 75 cents ($7.75-$7.00= $0.75).  By using this strategy Bob is only down 10 cents on the trade.  Bob’s new breakeven is $6.70 and the futures is now trading at $6.60.  Had Bob only bought the futures at $7.00, Bob would be down $0.40 cents on the trade.

As you can see, this strategy does not remove all risk from the trade, but it does provide an alternative to trading the outright futures contract only. Like any trading strategy, it is important to enter the trade with a predetermined game plan, remain disciplined and stick to the plan.  Managing risk will still be a key component to your overall success as a trader, but this strategy can be used to help hedge your position’s risk.

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Filed Under: Tips & Strategies

About Nick Metzger

Nick Metzger serves as a Senior Broker with Daniels Trading. Nick earned his B.A. in finance and economics from Northwood University. Along with his success in the classroom, Nick excelled on the baseball field as a 4-year starter and team captain. Upon graduation, Nick carried his determination on the field to the financial markets. He began his career with a firm that specialized in option trading where he learned how to evaluate market fundamentals with a technical overlay for timing trades.

Craving employment with a firm offering more diverse execution services, Nick relocated to Chicago and joined Daniels Trading. Since joining Daniels Trading Nick has broadened his execution offerings. He now prides himself in matching clients assets with a wide array of trading opportunities including, broker execution, online trading, automated trading systems, and managed futures.

Risk Disclosure

WHEN INVESTING IN THE PURCHASING OF OPTIONS, YOU MAY LOSE ALL OF THE MONEY YOU INVESTED.

WHEN SELLING OPTIONS, YOU MAY LOSE MORE THAN THE FUNDS YOU INVESTED.

HYPOTHETICAL PERFORMANCE RESULTS HAVE MANY INHERENT LIMITATIONS, SOME OF WHICH ARE DESCRIBED BELOW. NO REPRESENTATION IS BEING MADE THAT ANY ACCOUNT WILL OR IS LIKELY TO ACHIEVE PROFITS OR LOSSES SIMILAR TO THOSE SHOWN. IN FACT, THERE ARE FREQUENTLY SHARP DIFFERENCES BETWEEN HYPOTHETICAL PERFORMANCE RESULTS AND THE ACTUAL RESULTS SUBSEQUENTLY ACHIEVED BY ANY PARTICULAR TRADING PROGRAM.

ONE OF THE LIMITATIONS OF HYPOTHETICAL PERFORMANCE RESULTS IS THAT THEY ARE GENERALLY PREPARED WITH THE BENEFIT OF HINDSIGHT. IN ADDITION, HYPOTHETICAL TRADING DOES NOT INVOLVE FINANCIAL RISK, AND NO HYPOTHETICAL TRADING RECORD CAN COMPLETELY ACCOUNT FOR THE IMPACT OF FINANCIAL RISK IN ACTUAL TRADING. FOR EXAMPLE, THE ABILITY TO WITHSTAND LOSSES OR TO ADHERE TO A PARTICULAR TRADING PROGRAM IN SPITE OF TRADING LOSSES ARE MATERIAL POINTS WHICH CAN ALSO ADVERSELY AFFECT ACTUAL TRADING RESULTS. THERE ARE NUMEROUS OTHER FACTORS RELATED TO THE MARKETS IN GENERAL OR TO THE IMPLEMENTATION OF ANY SPECIFIC TRADE PROGRAM WHICH CANNOT BE FULLY ACCOUNTED FOR IN THE PREPARATION OF THE HYPOTHETICAL PERFORMANCE RESULTS AND ALL OF WHICH CAN ADVERSELY AFFECT ACTUAL TRADING RESULTS.

STRATEGIES USING COMBINATIONS OF POSITIONS, SUCH AS SPREAD AND STRADDLE POSITIONS MAY BE AS RISKY AS TAKING A SIMPLE LONG OR SHORT POSITION.

The StoneX Group Inc. group of companies provides financial services worldwide through its subsidiaries, including physical commodities, securities, exchange-traded and over-the-counter derivatives, risk management, global payments and foreign exchange products in accordance with applicable law in the jurisdictions where services are provided. References to over-the-counter (“OTC”) products or swaps are made on behalf of StoneX Markets LLC (“SXM”), a member of the National Futures Association (“NFA”) and provisionally registered with the U.S. Commodity Futures Trading Commission (“CFTC”) as a swap dealer. SXM’s products are designed only for individuals or firms who qualify under CFTC rules as an ‘Eligible Contract Participant’ (“ECP”) and who have been accepted as customers of SXM. StoneX Financial Inc. (“SFI”) is a member of FINRA/NFA/SIPC and registered with the MSRB. SFI does business as Daniels Trading/Top Third/Futures Online. SFI is registered with the U.S. Securities and Exchange Commission (“SEC”) as a Broker-Dealer and with the CFTC as a Futures Commission Merchant and Commodity Trading Adviser. References to securities trading are made on behalf of the BD Division of SFI and are intended only for an audience of institutional clients as defined by FINRA Rule 4512(c). References to exchange-traded futures and options are made on behalf of the FCM Division of SFI.

Trading swaps and over-the-counter derivatives, exchange-traded derivatives and options and securities involves substantial risk and is not suitable for all investors. The information herein is not a recommendation to trade nor investment research or an offer to buy or sell any derivative or security. It does not take into account your particular investment objectives, financial situation or needs and does not create a binding obligation on any of the StoneX group of companies to enter into any transaction with you. You are advised to perform an independent investigation of any transaction to determine whether any transaction is suitable for you. No part of this material may be copied, photocopied or duplicated in any form by any means or redistributed without the prior written consent of StoneX Group Inc.

© 2023 StoneX Group Inc. All Rights Reserved

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Risk Disclosure

The StoneX Group Inc. group of companies provides financial services worldwide through its subsidiaries, including physical commodities, securities, exchange-traded and over-the-counter derivatives, risk management, global payments and foreign exchange products in accordance with applicable law in the jurisdictions where services are provided. References to over-the-counter (“OTC”) products or swaps are made on behalf of StoneX Markets LLC (“SXM”), a member of the National Futures Association (“NFA”) and provisionally registered with the U.S. Commodity Futures Trading Commission (“CFTC”) as a swap dealer. SXM’s products are designed only for individuals or firms who qualify under CFTC rules as an ‘Eligible Contract Participant’ (“ECP”) and who have been accepted as customers of SXM. StoneX Financial Inc. (“SFI”) is a member of FINRA/NFA/SIPC and registered with the MSRB. SFI does business as Daniels Trading/Top Third/Futures Online. SFI is registered with the U.S. Securities and Exchange Commission (“SEC”) as a Broker-Dealer and with the CFTC as a Futures Commission Merchant and Commodity Trading Adviser. References to securities trading are made on behalf of the BD Division of SFI and are intended only for an audience of institutional clients as defined by FINRA Rule 4512(c). References to exchange-traded futures and options are made on behalf of the FCM Division of SFI.

Trading swaps and over-the-counter derivatives, exchange-traded derivatives and options and securities involves substantial risk and is not suitable for all investors. The information herein is not a recommendation to trade nor investment research or an offer to buy or sell any derivative or security. It does not take into account your particular investment objectives, financial situation or needs and does not create a binding obligation on any of the StoneX group of companies to enter into any transaction with you. You are advised to perform an independent investigation of any transaction to determine whether any transaction is suitable for you. No part of this material may be copied, photocopied or duplicated in any form by any means or redistributed without the prior written consent of StoneX Group Inc.

© 2023 StoneX Group Inc. All Rights Reserved

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