Understanding Options Strategies: Covered Calls and Cash-Secured Puts
Options trading can be a powerful tool for investors looking to enhance their portfolios, particularly through strategies like covered calls and cash-secured puts. In this article, we’ll explore these strategies using Alibaba (BABA) as a case study, detailing what happens if BABA ends above or below the strike price at expiry. We’ll also discuss how these strategies fit into the plans of cautious, long-term investors.
Covered Call Strategy
What is a Covered Call?
A covered call involves selling call options on shares you already own. This strategy allows you to generate income from the premiums received while still holding onto your shares.
Scenario Analysis
If BABA Ends Above Strike Price at Expiry:
You sell a $128 call option on shares you own.
If BABA closes above $128, your shares will be sold at this price.
Net Effect: You receive $128 per share, keep the premium from the option sale, and any dividends paid out.
Max Gain Calculation:
[
\text{Max Gain} = (128 – 120.20) \times 100 + \text{Premium} + \text{Dividend}
]
If assigned, you profit from the sale of shares and the premium collected.
If BABA Ends Below Strike Price at Expiry:
Your shares are not called away.
Net Effect: You keep your shares, the premium from the option sale, and any dividends.
You can try selling another call option in the next cycle, potentially generating more income.
Summary of Covered Call Outcomes
Above Strike: Sell shares at $128, keep premium and dividends.
Below Strike: Keep shares, keep premium and dividends.
Cash-Secured Put Strategy
What is a Cash-Secured Put?
A cash-secured put involves selling put options while holding enough cash to purchase the shares if assigned. This strategy is ideal for investors looking to buy shares at a lower price while earning income from premiums.
Scenario Analysis
If BABA Ends Above Strike Price at Expiry:
You sell a $113 put option and hold €11,300 in cash.
Net Effect: You keep the premium received from selling the put, and no shares are bought.
Max Gain: The premium collected is your total gain.
If BABA Ends Below Strike Price at Expiry:
You are assigned and must buy 100 shares at $113.
Net Effect: You purchase shares at a lower effective price (strike price minus premium).
If the premium was, say, $1.22, your effective purchase price would be:
[
113 – 1.22 = 111.78
]
This price is lower than the current market price, providing a potential bargain.
Summary of Cash-Secured Put Outcomes
Above Strike: Keep premium, no shares bought.
Below Strike: Assigned shares at $113, effective purchase price lower than current market.
How Do These Strategies Fit Cautious, Long-Term Investors?
Income Focus
Both strategies provide upfront income through premiums, and for covered calls, there’s the added benefit of dividends. This income can be reinvested or used to offset other investment costs.
Risk Control
With covered calls, you’re either selling at a profit or holding onto your shares. For cash-secured puts, you’re either buying shares at a discount or keeping the premium without any obligation.
No Leverage
These strategies do not require borrowing or using margin, which limits the risk of losses beyond your initial investment. This is particularly appealing for conservative investors.
Clear Outcomes
Both strategies offer clearly defined best and worst-case scenarios, allowing investors to make informed decisions based on their risk tolerance and market outlook.
Frequently Asked Questions
What if the Share Price Moves Sharply Before Expiry?
Your outcomes remain predetermined. With a covered call, your upside is capped, but you retain the premium. With a cash-secured put, if the option isn’t exercised, you keep the premium; if it is, you must buy at the strike price.
Can I Get Out of the Trade Early?
Yes, you can buy back the option at any time. Depending on market conditions, this may result in a gain or loss.
Why Do I Need to Set Aside the Full Cash Amount for the Put?
This requirement ensures you have sufficient funds to cover the potential purchase of shares if assigned, limiting your risk to the amount you’re willing to invest.
Conclusion
Options strategies like covered calls and cash-secured puts offer long-term investors additional avenues to enhance their portfolios. Whether generating income from existing shares or acquiring quality stocks at a lower price, these strategies provide transparency, simplicity, and control.
At Saxo, we believe that incorporating carefully selected options strategies can help you navigate market fluctuations and pursue steady returns, even in uncertain times. Before diving in, take the time to review your investment objectives and leverage the resources available to you for a deeper understanding of how options can support your long-term goals.
