Question

Suppose that you wish to buy a stock and protect yourself against a downside movement in its price. You consider both a covered call and a protective put. What factors will affect your decision?

Answer 1

Covered call strategy : Covered calls are an options strategy where an investor holds a long position in an asset and writes (sells) call options on that same asset to generate an income stream as a higher premium is received from selling calls.

A protective put position is created by buying (or owning) stock and buying put options on a share-for-share basis.

The factors that will affect my decision is :

The protective put strategy limits the loss for the owner of the stock when the prices of the stock falls. As the person holding the stock gains from the put option, in case prices start falling.  Buying a put option to add to an underlying long position provides downside protection while still retaining upside potential.

In case of covered calls, the owner of stock sells a call option and gains from the premium earned from the sale of the call. Selling a covered call in which the stock is owned reduces the overall risk. An investor will choose this strategy only if he doesn't expect the stock prices to rise too rapidly. The downside risk will be limited to the amount of premium received. However, selling a covered call to reduce risk also has the effect of limiting potential gains.

If the holder of stock believes that the prices of stock will not rise rapidly, he should buy a covered call strategy. As, this strategy can limit his upside potential and also enjoy premium by sale of call.

If, the investor wants to enjoy the upside, and also gain if prices fall he should buy a protective put strategy. When he is not sure of the stock price movements.