Covered Calls and Spreads: A Closer Look At How To Use Options
Once you’re confident trading stocks, you may want branch out into options trading. Adding options to your investment strategy can add depth to your portfolio, boost gains and reduce risk. You may already know how puts and calls work. Now you need to figure out how to use them effectively to take advantage of all the benefits option trading possesses.
A covered call is bullish option strategy that helps reduce downside risk. It works in conjunction with owning the underlying stock but limits overall upside. Let’s use a hypothetical stock as an example:
Let’s say you own 100 shares of XYZ stock trading at $25 and you think the stock is going to go up in the next few months but you want to protect yourself if the stock drops as well. You sell a call for $50 a few months out at $30 per share and pocket the $50 gain.
If the stock closes higher than $25 but less than $30, the call will expire worthless and you’ll keep the $50 profit plus you’ll still own 100 shares of XYZ. If the stock climbs above $30 per share, you’ll be forced to sell the call at $30 but you keep the $50 profit plus the $5 gain in the stock’s rise for a total of $550. That means you lose out on any upside beyond $30 so if it suddenly umps up to $40 per share, you won’t get the $10 increase past $30.
Because you sold a call for $50, this also helps reduce downside risk by making your breakeven price $24.50. If the stock falls below that price then you’ll realize a loss, but there’s a bit of wiggle room where you’ll still have a gain even if the stock does nothing or even drops a little.
There are two types of spreads: bullish and bearish. In this type of option strategy, you use two options with the same expiration date but different strike prices. This can be a good way to reduce the cost of entering into a trade or betting on a potential rise or drop in price without actually buying a stock or selling it short.
Let’s use an example to illustrate how this works:
XYZ stock is currently trading at $25 per share and you think it might go up in the next few months but aren’t willing to buy 100 shares of the stock. You could purchase a call option for $250 a few months out at $25 and sell another call for $50 at a higher strike price of $30. Your total cost for entering into this trade is $200 making this the total amount you could lose.
Your total possible profit is $500 minus the $200 cost of purchasing the two options. Using this strategy allows you to leverage your money and increase profits while reducing your total monetary investment while doing so. This works the same way with bear spreads as well except instead of using calls you would use puts.
Covered calls and spreads are simple option strategies that can help your investment portfolio reach its full potential. But there are dozens of possible combinations and strategies you can use in addition to these. Once you get a feel for spreads and covered calls, you may want to look into more complicated strategies that can help you profit no matter what direction the market goes – up, down or even when it does nothing at all.