Options Trading Basics: Using Covered Calls and Protective Puts

• Covered calls generate income by selling call options against shares you own, which can lower cost basis but caps upside.
• Protective puts act like insurance, limiting downside for a cost called the put premium, useful during uncertainty.
• Key option metrics are implied volatility, delta, days to expiration, and open interest; they guide strike and expiry choices.
• Use covered calls when you’re mildly bullish to neutral, and protective puts when you want downside protection without selling shares.
• Combine both tools in practical ways, such as collar strategies, to balance income and protection.

Introduction

Options are contracts that give you the right to buy or sell a stock at a set price before a certain date. This article focuses on two beginner-friendly strategies, covered calls and protective puts, which help you generate income or reduce risk while holding stocks.

Why does this matter to you? If you own shares or plan to buy shares, options can change how you manage risk and returns. You don't need to be a trader to use these tools, but you should understand the mechanics and the tradeoffs.

You'll learn what each strategy does, when to use it, how to pick strikes and expirations using simple analytics, and common mistakes to avoid. Real-world examples using $AAPL and $TSLA make abstract ideas tangible.

Understanding Options Basics

There are two basic option types: calls and puts. A call gives the buyer the right to buy the stock at the strike price. A put gives the buyer the right to sell the stock at the strike price. Sellers, sometimes called writers, take the opposite side and receive a premium.

Key terms you'll see often include strike price, expiration date, premium, implied volatility, delta, and open interest. Implied volatility, or IV, estimates the market's expectation of future movement and helps price options. Delta estimates how much an option's price moves when the underlying stock moves $1.

Options are quoted per share but trade in contracts of 100 shares. That means one option contract controls 100 shares and premiums are quoted on a per-share basis. Keep position sizing in mind because options can magnify outcomes.

Covered Calls: Generating Income from Stocks

A covered call is when you own shares and sell call options against the same shares. You collect the option premium up front. If the stock stays below the strike, you keep the premium and continue holding the shares. If the stock rises above the strike, you may have to sell your shares at the strike price.

Covered calls are best when you're mildly bullish to neutral and willing to cap upside in exchange for income. This strategy lowers your effective cost basis by the premium amount, which improves return if the stock stays flat.

How to choose strike and expiration

1. Pick an expiration timeframe: weekly, monthly, or longer. Shorter expirations have faster time decay but smaller premiums. Monthly expirations are common for beginners.
2. Choose a strike: you can sell at-the-money (ATM), slightly out-of-the-money (OTM), or deeper OTM. OTM strikes give more upside potential but less premium. ATM gives higher premium but less room to run.
3. Check implied volatility and open interest: higher IV means higher premiums, but also implies more expected stock movement. Open interest shows liquidity; higher is better for entering/exiting.

Example: You own 100 shares of $AAPL trading at $170. You sell one monthly $175 call for $2.00 (premium $200). If $AAPL stays below $175, you keep $200 and your shares. Your effective cost basis is lowered by $2.00 per share. If $AAPL rises above $175, your shares are likely sold at $175, giving you stock upside to the strike plus the premium.

When to use covered calls

• You want to generate recurring income on a long-term holding.
• You expect limited upside over the option timeframe.
• You’re comfortable selling shares at the strike price.

Protective Puts: Insurance for Your Shares

A protective put is when you own shares and buy put options to limit downside. This works like insurance: you pay a premium, and in exchange you have the right to sell at the put's strike, even if the market falls below that price.

This strategy is useful if you want to keep the stock for long-term reasons but fear near-term volatility. The cost of protection is the premium, which reduces your net return if the stock doesn't fall.

How to choose strike and expiration

1. Decide the level of protection: a put at 90% of current price protects you to 90% of your current value. Deeper protection costs more.
2. Pick expiration based on the risk window: short-term puts protect against immediate events, longer-term puts protect over months but cost more overall.
3. Use delta as a proxy: a put with delta -0.30 has roughly a 30% chance of finishing in-the-money from a statistical perspective. Lower delta is cheaper but offers less likelihood of payout.

Example: You own 100 shares of $TSLA trading at $220 and are worried about an upcoming earnings report. You buy a one-month $200 put for $6.00 (premium $600). If $TSLA drops below $200, you can sell at $200, limiting your loss. If $TSLA rises or stays above $200, the put expires worthless and you lose the $600 premium.

Using Analytics to Choose Options

Choosing strikes and expirations is where analytics help. You don't need complex models; start with a few key metrics and simple calculations you can do on any options chain.

Key metrics and simple rules

• Implied Volatility (IV): Higher IV means higher premium. If IV is high relative to the stock's historical volatility, options are expensive. Consider selling calls when IV is high and buying protection when IV is lower if you want cheaper insurance.
• Delta: Use delta as a rough probability. For covered calls, selling a call with delta 0.20 means about a 20% chance of assignment by expiration. For puts, delta indicates likelihood of finishing in the money.
• Time decay (theta): Shorter expirations lose value faster. Sellers benefit from theta; buyers pay theta.
• Open interest and bid-ask spread: Look for liquid strikes. Tight spreads reduce trading costs.

Practical selection steps

1. Decide your goal: income, protection, or both.
2. Check IV rank: many platforms show IV rank. If IV rank is high, premiums for selling are richer.
3. Pick delta-based strikes: e.g., sell calls at delta 0.15-0.30 for income, buy puts at delta 0.20-0.35 for reasonable protection vs cost.
4. Run the math: calculate max gain, break-even, and worst-case outcomes for the time frame you care about.

Example calculation: You own $MSFT at $350. You sell a $360 call for $3.00 and buy a $330 put for $4.00, creating a collar. Net cost is $1.00 paid, which reduces upside slightly and buys downside protection to $330. If $MSFT falls to $320, the put limits loss to roughly $20 plus the $1 net cost.

Common Mistakes to Avoid

• Ignoring assignment risk: If you sell calls, you might have shares called away at expiration. Avoid surprise assignments by monitoring ex-dividend dates and earnings.
• Buying protection without a plan: Buying puts repeatedly can become expensive. Use protection when you have a clear reason, like a known catalyst or a near-term liquidity need.
• Choosing illiquid strikes: Wide bid-ask spreads increase trading costs and make exits costly. Stick to strikes with decent open interest.
• Overleveraging: Options magnify returns and losses. Don't use option positions that risk more than you can afford to lose, especially when selling options uncovered.
• Forgetting tax and fees: Options trades can create short-term taxable events. Understand how option profits and assignment affect your tax lot tracking.

FAQ

Q: Can I lose my shares when I sell covered calls?

A: Yes. If the stock is above the call strike at expiration, you can be assigned and your shares will be sold at the strike price. That outcome is part of the trade-off for collecting premium.

Q: How much does a protective put usually cost?

A: Put costs vary with implied volatility and time to expiration. Short-dated puts with low IV can be a few percent of share price, while long-dated or high-IV puts can cost considerably more. Expect to pay the premium up front as the insurance cost.

Q: Can I use covered calls and protective puts together?

A: Yes, combining them creates a collar, which limits downside while capping upside. Selling calls can help offset the cost of buying puts, but the net structure determines how much protection and income you actually get.

Q: Are options only for advanced traders?

A: No. Options can be used by beginners if you start with basic strategies like covered calls and protective puts, learn the terminology, and manage position size. Education and simple analytics reduce the learning curve.

Bottom Line

Covered calls and protective puts are practical option strategies for investors who already own shares. Covered calls generate income and lower your cost basis but limit upside. Protective puts buy downside protection at the cost of a premium, acting as insurance.

Use a few simple analytics, like implied volatility, delta, and open interest, to choose strikes and expirations that align with your goals. Practice with small positions, track assignment risk, and avoid illiquid contracts.

Next steps: review options chains on a platform you trust, try paper-trading a covered call and a protective put on a small position, and read more about implied volatility and delta to build confidence. At the end of the day, options are tools, and used carefully they can help you manage income and risk in your portfolio.