Adding Covered Calls & Naked Puts to Your Investment Strategy

For those who manage their own equities portfolio, rather than relying solely on mutual funds for investment income or for long-term retirement planning, there are some very basic options strategies that may add to returns without substantially increasing risk. Now, for the most part, financial pundits will warn novice investors of the dangers of options trading. In one sense, these warnings are well-meaning, as improper options strategies can lead to financial ruin. However, there are a handful of very basic option trading techniques that are easy to comprehend, easy to execute and no more risky than investing in equities themselves.

Options Basics

For those entirely unfamiliar with options, they are simply a contract that obligates the option seller - also referred to as the "writer" - to buy or sell shares of a given stock at a given price. Conversely, purchasing an option gives the buyer the right, but not the obligation, to purchase or sell shares at a given price. Options always have an expiration date, at which point the contract is no longer in effect and at which time no further obligation or right exists. Additionally options "contracts," which is technically what is purchased or sold in an options trade, are for 100 shares of a given stock, thus allowing the option purchaser to "control" 100 shares of the given security.

"Call" options give the buyer the right to buy, or "call away," shares from the call option writer, while "Put" options give the buyer the right to sell, or "put to," the put option writer. It should be clarified that the market matches buyers and sellers of options - there is no pre-determined individual on the other side of your option trade.

Let's look at an example: If shares of IBM are trading for $125 per share in July, a $130 call option (the $130 amount being referred to as the "strike price") with an expiration in August may be priced at $.95. In this instance, the cost of a single contract would be $95 ($.95 x 100). The purchases of the call option will give the buyer the right to purchase 100 IBM shares for $130 per share up to the expiration date. The option buyer will "exercise" this option, typically at or near expiration date, if the shares go above $130 (technically, the shares would have to go above $130.95 to offer a net gain, since $.95 per share was paid for the option contract, referred to as the "premium"). Note that because options are traded on the major exchanges, the owner of an option contract always has the ability to sell the option contract as well, and this happens far more frequently than options actually being exercised.

Put options work in much the same manner, but in reverse. Purchasing a put option on those same IBM shares at a theoretical strike price of $120 would allow the buyer to sell 100 shares of IBM at $120. If the price of IBM goes below $120 (technically, $120 less the option premium paid), the put buyer can sell the shares at the strike price even if the market price of the shares is well below that level. The difference between the market price and strike price represents the put buyer's gain.

Now that we have the basics covered, let's take a quick look into two strategies that can help the average investor add to their portfolio's net gain.

Covered Calls

Call options are said to be "covered" when the option writer owns the underlying shares. In the IBM example from above, that means the writer would own 100 shares of IBM stock and would write a call contract for an immediate $95 gain (note that in all examples, we are not taking into account the cost of executing trades). If the price of IBM reaches the strike price of $130, the call writer will have his or her shares "called" away. Note, however, that the transaction of having the shares called will actually result in a gain on the stock sale as well, assuming that the shares were purchased for less than the $130 strike price. If the expiration date of the option contract comes and goes without the strike price being reached, the call writer simply pockets the $95 and is free to write another option or, technically, "roll over" the option to the next month.

One particular strategy would be to purchase the IBM shares at market ($125) and immediately write the call. The net gain on this trade would be $95 for the call write and $625 for selling the shares when they are called away. Ultimately, the call writer will not have been able to participate in the full upside of the IBM shares - if they have gone significantly above $130 - but has the immediate gain associated with writing the call. Of course, if the investor in this hypothetical situation would like to continue to own those shares, he or she can simply purchase an August $130 call to close the position, thus allowing continued ownership of the shares.

Naked Puts

Options are referred to as "naked" when the writer of the option does not own the underlying shares with which the option is associated. While the concept of naked options frightens many investors, naked puts can be viewed simply as an attempt by an investor to purchase a stock that he or she already would like to own at a discount to the current market price.

Let's go back to the IBM example. You've done all the research on IBM and feel that it's worth every bit of its $125 market price. You'd like to buy it at $125, but instead decide to write a put. Doing so allows you to pocket the $95 immediately. Then, if the share price of IBM drops below $120 (the strike price), hopefully (yes, HOPEFULLY), the shares will be "put" to you. Now, you own shares of IBM at $120 even though you considered it to be worth $125. You also have the $95 gain from writing the put option.

It is important to note that some who venture into put writing will tend to chase the highest premium. That is, they will search for stocks that offer the most return for writing a put contract and act accordingly. In the safer version of writing naked puts, however, the writer should have no aversion whatsoever to purchasing the underlying shares and, in fact, should be pleased to have acquired the shares at a price less than the shares' perceived value.

Properly implementing a system of writing naked puts and covered calls to increase returns can lead to greater returns for small investors while adding an acceptable level of risk.