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Buying Put Options & Covered Calls
The Smart Profits Report: Issue #325
Monday, July 3, 2006
Buying Put Options & Covered Calls: Two Ways To Play A Downside Trend
By Lee Lowell
Advisory Panelist, Mt. Vernon Research
With Independence Day here, summer is in the air. Traditionally, this is the most uneventful time for the markets. But not this year! The temperature’s been rising, and so has volatility. In fact, I haven’t seen swings this big in a while. And with the summer historically a selloff time, you need to be prepared.
When economists mention “shorting the market” or “shorting Company XYZ,” they believe the market/company is headed down. But the market is pretty flexible and offers several alternatives.
Here are two ways to play a downside trend:
- Take a bearish position on your long securities to protect yourself; or
- Play the downside of the market/company outright.
Let’s look at each of these tactics for protecting your portfolio, including buying put options and covered calls…
A Long Stock Insurance Policy
If you are long a stock, you can protect yourself in a couple of ways.
- The most familiar way is to simply buy protective put options against your long position.
- Alternatively, you could sell call options against your long position - known as a “covered call.”
We’ll get to this in a moment.
Think of buying protective puts in terms of your house or car insurance. You’re basically protecting yourself against an unforeseen event. You pay your premiums to the insurance company and if something bad happens, you collect your payout. But you’re probably not going to use much of your insurance.
Just as some people view buying insurance as wasted money going to the insurance company, some also view buying put options as wasted money going to the seller. But that’s not always the case…
Protect Against Market Downturns With Put Options
There are many times when buying put options is hugely advantageous in protecting you against downturns. You just need to decide the strike price and expiration date for your options. If the stock never falls below the strike price, your options will expire worthless and you’ll lose the money - just as you would if you paid house insurance every month and your house never burned down.
Take a look at this options chain, showing October 2006 put options available for Walt Disney Corp. (NYSE: DIS).
DIS is trading at $29.47. But if you think it’s temporarily going lower, you can protect your long position by selling out if DIS trades down to a certain level.
If your cost basis is $22 a share, you want to protect those gains and sell somewhere higher than that. Let’s say you opt to buy the $27.50 puts for $0.80 a contract. This allows you to sell your DIS shares for $27.50 anytime until expiration. That would give you a net sell price of $26.70 (by subtracting the option premium from the strike price: $27.50 minus $0.80 = $26.70). If DIS trades below $27.50 by expiration, you can exercise your put options and bank a net gain of $4.70 per share ($26.70 minus $22 = $4.70).
Don’t Want To Buy Puts… Use A Covered Strategy
If you don’t want to buy puts outright, you could employ a “covered call” strategy against your long position.
This is where you sell a call option…
- at a strike price where you’d be willing to sell your stock, or…
- at a higher level that you don’t think the stock will hit.
When you sell a call option, you are obligated to sell your shares at that strike price if they reach that level.
Let’s see how this works in reality, using Walt Disney again, but this time using calls.
The Covered Call Strategy At Work
Say you own 300 shares of DIS with a cost basis of $22 per share. You think the company will endure three months of downside and want to protect yourself.
You can sell three call options against your 300 long shares. You just need to pick a strike price and an expiration that you’re comfortable with.
The option chain above shows the DIS October 2006 options.
In this trade, you could sell the $32.50 call options and receive $0.60 for them. That would give you $180 ($0.60 x $100 x 3 = $180). You get the $180 upfront - yours, no matter what.
What you don’t want is for DIS to trade above $32.50 by the October expiration, otherwise you’ll be obligated to sell your 300 shares at $32.50. Even if DIS rallies to $40, you’d still have to sell at $32.50. This is why I recommend only selling call options at a level that’s comfortable for you.
But if DIS never trades up to $32.50 by October, the trade expires and you get to keep your shares, in addition to the $180. A good deal - and you can repeat the process if you wish.
Three More Ways to Play the Downside
Now let’s tackle the second alternative mentioned earlier - an outright bearish position in a security. You can do this a few ways:
- Sell short the shares of any stock or ETF (very risky)
- Sell naked short calls (extremely risky)
- Buy deep-in-the-money put options (highly recommended!)
Beware! Shorting shares or selling naked call options entails unlimited risk. Never do that. Imagine being caught short in a stock while it’s rocketing higher against you. I’ve been in this position and it’s no fun, both financially and emotionally. Avoid these risky plays.
Want To Take A Bearish Position? Buy Put Options
I always opt for the deep-in-the-money (DITM) options. A DITM put is one whose strike price is much higher than the current price of the stock.
If you want to trade the whole market, I recommend buying put options on S&P Depository Receipts (AMEX: SPY), the S&P 500 tracking ETF, which is very liquid.
The SPY is currently trading around $127. So you’d buy DITM put options with a strike price at the $130 level or higher. Why? Because DITM options price will move very quickly in your favor if you’re right in picking which direction the market will go.
Happy Independence Day,
Lee Lowell
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Today’s Smart Profits Cribsheet
- Some investors are deterred by slightly more involved trading strategies like “covered calls.” Don’t be! It’s a mistake that could see you spurn some excellent profit opportunities. Take advantage of our Smart Profits Glossary to learn more about covered calls.
- Broaden your education and learn how writing covered call options can double your stock profits in Smart Profits #128, Writing Covered Calls: How to Double Your Stock Profits with Options.
Related Articles:
- Selling Covered Calls: Getting Cash for Stocks You Already Own
- Deep In-The-Money Covered Calls: How to Beat Stocks with Less Risk
- Covered Call Options: Turning A Stagnant Stock Into An ATM
