John Jagerson

Combining Covered Calls and Protective Puts

    Tweet This

Free Trading Guides

This article is brought to you by LearningMarkets.com.

Selling covered calls against a long stock or ETF position is a great way to hedge risk and smooth volatility.

For example, selling a covered call on the S&P 500 (SPX) on a monthly basis has shown to not only reduce volatility but to increase returns over the long term.

However, considering the current market conditions, many investors are looking for even more protection against market downturns.

Trading a covered call/protective put combination can be a great way to harvest many of the benefits of a covered call while maintaining fixed risk to the downside. This strategy combines two of the most common uses for options; both of which are focused on protecting against losses while still providing the opportunity for profits.

The strategy is relatively simple. In the accompanying video I will walk through a case study using the iShares Russell 2000 Index (IWM) by selling an at-the-money call against a long position in this ETF (the covered call) and buying an out-of-the-money put (the protective put) to limit losses.

The short call will provide a premium for potential profits and the protective put limits the risk in the position.

For example, assume that you were interested in dipping back into the market following the March 2009 rally. IWM looks like an interesting opportunity, but is at a potential resistance level and stepping in at this point with an outright long position may be too risky.

To improve the risk profile of this position you could sell an at-the-money covered call and then buy an out-of-the-money put -- both with April expirations.