Investing in the stock market is a smart way to grow wealth. Many investors, particularly those with some stock trading experience, venture into the world of options trading in addition to traditional stock buying and selling. Options trading presents its own set of terms and strategies investors should familiarize themselves with before making their first contract purchase. If you’re interested in mastering derivative strategies like covered puts, take the time to learn about options trading overall.
What Is Options Trading?
Image via Flickr by IN 30 MINUTES Guides
Options trading is the purchase of a contract that gives you the opportunity to buy or sell the stock associated with the contract if you choose to. It’s more complicated than simply purchasing or selling a stock share since there are price limits and expiration dates associated with every contract. Often, options contracts represent 100 shares of the underlying asset, but that can differ from contract to contract. Options are also called derivatives since they derive their value from the underlying asset rather than from the contract itself.
Options trading frequently carries more risks for a put option investor than traditional trading due to the unique and specific circumstances outlined in each contract, but by contrast, the potential for a return on investment is much higher than with traditional market sales.
Calls vs. Puts
Many investors trade options alongside traditional stocks as a way to increase income, hedge other investments, or speculate. When trading options, the purchase of a contract is known as a “call” and the sale is called a “put.” Investors can use a variety of strategies using calls and puts to optimize their trades, like:
- Covered calls
- Covered puts
- Married puts
- Bull call spreads
- Bear put spreads
- Long call butterfly spreads
Of these call- and put-specific strategies, the most commonly used are the covered call and the covered put:
A covered call is an options trading strategy in which the investor purchases stock from a company and simultaneously purchases a call option for the same number of company shares. The main benefit of this approach is the protection from significant losses. Once the options contract sells, the investor collects the premium from the initial stock sale and adds some downside loss protection.
A covered put is essentially the inverse of a covered call. Rather than purchasing the stock in the hopes that its value will go up, investors short the stock and place a put contract on the same shares in a covered put. In this scenario, the investor gets paid immediately from the premium but does run the risk of substantial downside losses.
Things to Know About Covered Puts
Covered puts can be a risky options strategy. Keep these three factors in mind when assessing a potential covered put:
- Covered puts cap the upside potential on the trade.
- There’s no limit to the downside on covered puts.
- Covered puts can be a useful tool for generating income through the premiums.
Investors can see dramatic returns when using stock trading and options contracts in tandem through effective strategies. Before making any calls or puts, however, ensure you understand the potential risks.