There is a defensive strategy while writing covered calls, which consists of also buying a put. With a “traditional” covered call, the investor owns the stock if it is not trading at or above the strike price. When buying a put, the investor has the ability to sell the stock at a given price, even if the stock is trading below that price. This technique gives the investor the ability to sell his stock at a guaranteed price, thereby limiting the amount he can lose on the transaction. This can be a very confusing concept initially, but read on and it should become clear.
In order to understand this technique, it is important that you first have a basic understanding of puts. A put gives the holder of the option contract the right to SELL the stock to the writer for a specified price on the strike date. What this means is that you can buy the right to sell your stock to someone at a certain price. In the example below, we are going to pay someone for the right to sell them our stock at $45 a share. The cost of the $45 put is $3 a share. This means that we have to pay $3 per share for the right to sell our stock to someone at $45, no matter where it is currently trading. If the current stock price is $20, we can still sell our stock for $45.
Here is the example, XYZ stock is trading at $50 a share, and the bid on the $50 call is $5. The covered call has downside protection of 10% and a yield if called of 10%, with a break-even point of $45. If the stock is trading below $50 a share on the strike date, you will still own the stock. If the stock falls to $30 a share, you will incur a loss of $15 (45-30) a share.
By buying a put, you can limit your downside because you have bought yourself the right to sell your stock at a certain price. In this example, we are going to buy a $45 put for $3 a share. $45 is our breakeven point, so it makes sense to buy a put at this price. A put at a higher price will cost more, and we want to limit the amount we are paying. A put at a lower price costs less, but you have also received less protection.
The math on our transaction is now different. While we received $5 a share for selling the call, we had to pay $3 a share to buy the put. This means that our net per share is only $2 (5-3). Our downside protection is now 4% ((5-3)/50)), and our yield if called has also been lowered to 4% ((50-50) +2)/50)). Our break-even point has also been raised to $48 a share (50-5+3). However, the most we can lose on this transaction is $3 a share (strike price on the put – breakeven point). This means that our maximum loss is 6%.
This strategy often looks great on paper, and the example listed above is created from fictional numbers. This example was designed to be easy to understand.
The important thing to understand from this segment is the concept of a put, the structure of this transaction, and the math involved. Many investors may find that the addition of a put provides some additional insurance during a volatile market.
Now we will provide some real life examples in order to gain a more realistic understanding of this technique.
EXAMPLE 1: This example shows what might happen when you try this technique with a lower risk stock.
XYZ is trading at $86 1/2 a share, and the bid on the $85 call is $8. Our initial break-even point is $78 ½ (86 ½ -8). The closest put to our break-even point is the June $75 put, and it has an ask price of $3. Our combined transaction now has downside protection of 5.78%, a yield if called of 4.04% and a maximum potential loss of 7.51%.
While this is not necessarily a poor choice of investments, a yield of 4.04% (before commissions) may not be enough for many investors. However, the fact that your maximum loss would only be 7.51% makes the investment worth considering.
EXAMPLE 2: This example shows what might happen when you use a higher strike price for the put. Our goal is to find a transaction with the lo
Calls vs. Puts 
