Derivatives · Pro · 4 min

Basic strategies: covered call, protective put, spreads

You can explain three basic option strategies, what each gives up in exchange for what it gains, and calculate their best and worst outcomes.

Reshape the risk

Most beginners meet options as bets: buy a call if you think a share will rise. But options can also be combined with shares, or with each other, to change the shape of a position's risk.

These combinations are called strategies. The three in this lesson are among the most common. None of them is free: each one gives something up in return for what it offers.

Income, floor, limits

Covered call. A covered call means owning shares and selling a call option on them.

You receive the premium as income.
If the share rises above the strike, it is likely to be called away, so your gain is capped at the strike plus the premium.
If the share falls, the premium cushions the loss slightly, but most of the downside remains.

Protective put. A protective put means owning shares and buying a put on them.

The put gives you the right to sell at the strike, so losses below it are offset.
You pay the premium, whether or not the protection is needed, like an insurance premium.
The upside stays open, minus the premium.

Vertical spread. A vertical spread buys one option and sells another of the same type and expiry, with a different strike. A call spread, for example, buys a call at a lower strike and sells one at a higher strike.

The premium received for the sold option reduces the cost.
Both the maximum gain and the maximum loss are limited and known in advance.

The OCC's strategy guide and FINRA's materials describe these and many more combinations. All of them rely on the same building blocks: calls and puts, bought or sold.

6 instead of 15

A fictional investor owns 100 shares bought at 50.

Covered call: sells a call with a strike of 55 for 1. The stock jumps to 65. The shares are called away at 55. Gain per share: 5 + 1 = 6. Without the call, the gain would have been 15.
Protective put: buys a put with a strike of 45 for 1.50 instead. The stock falls to 35. The put is worth 10, so the loss per share is limited to 5 + 1.50 = 6.50 instead of 15.
Call spread: buys a 100 call for 6 and sells a 110 call for 2 on another stock. Maximum loss: 4. Maximum gain: 10 − 4 = 6.

Common mistakes

Seeing covered calls as free income. They cap the upside and leave most of the downside.
Buying puts too late. In a sell-off, implied volatility makes protection expensive.
Forgetting the costs of several legs. Each option has its own spread and fee.
Using strategies without calculating the extremes. Know the best and worst case first.

The takeaway

A covered call trades upside for income, a protective put trades a premium for a floor, and a spread caps both gain and loss. Every strategy trades something.

Check yourself

Quick quiz

4 questions. Instant feedback, nothing is saved.

1Tap the strategy that sets a floor under a share holding.

Tap the chart.

A put gives the right to sell at the strike, so losses below the strike are offset, for the price of the premium.
2You own shares at 50 and sell a 55 call for 1. The stock rises to 65. What is your gain per share?

Above 55, the shares are called away. Gain = (55 − 50) + 1 = 6, instead of 15 without the call.
3You buy a 100 call for 6 and sell a 110 call for 2. What is your maximum loss per share?

Net premium = 6 − 2 = 4. The maximum gain is the strike gap minus that: 10 − 4 = 6.
4What is the main cost of a protective put?

Like insurance, the premium is lost if the protection is not needed. Upside stays open.

of 4 correct.