Question

Explain how to build an covered call and covered put, what are the purposes of a covered call and covered put strategy? Build a real life Covered call and covered put for an American stock of your choice, pull the options contracts and paste them on the answer. Please explain each part of it, what the credit or debit will be for the transaction, include every detail of each option contract you will use to build the Covered call and covered put trades. These are two separate trades

Answer 1

Covered Call Strategy : when an investor has a long position in an underlying asset and writes (sells) out of money call options to either enhance the yield on the portfolio or as a short term hedge. The investor would be working with the expectation of short term negative to neutral price movement in the underlying asset and would believe that the call option will not be exercised. This way they will be able to earn some premium and/or hedge against short term negative price movement. If the investor believes in the longer term deterioration of the asset prices, then they are more likely to sell the underlying asset rather than sell options which is more short term in nature. The mechanics are explained below with an example of Apple stock:

• Current Apple stock price is $ 190.35 and the investor believes that due to certain events, the stock is not expected to cross 200 in the next 2 weeks and may even witness minor correction.
• The investor can sell July 20, call option at strike $200, which is quoting at $0.08 per unit
• So if an investor holds 100 Apple shares, they can sell 1 contract (contract size 100) at $0.08 and receive $ 8 as premium
• As long as the price is below $200 by expiry date of July 20, 2018 the investor will retain the $8 dollar premium. They will make loss only if the stock price moves above $200
• Exlcuding margin requirement, the investor receives $8 premium as credit on day 1 when the option is sold. On maturity the payout will be given by = - Max [(Expiry Price-Strike Price - Premium, - Premium] which is - Max [ (Expiry Price - 200 - 8), -8]

Covered Put is reverse of above where in an investor is short on an asset and may want to hedge against short term price upmove and sells puts. The expectation is only short term price upmove hence need for hedge otherwise the investor should square the short position in the underlying asset.

• Taking same examply of Apple stock , if an investor is short and current market price is $190.35 and believes that in the next 2 week the price will not go below $ 180, they can sell July 20 Apple put option with strike $180 for $0.22
• If they have 100 shares of Apple, they will sell 1 put contract and receive $22 as premium as credit (ignoring the margin required for selling option)
• The pay out on expiry will be = - Max [(Strike Price - Expiry Price - Premium, - Premium] which is = - Max [(180 - Expiry Price - 22), -22]