Options may be used in conjunction with stock positions to manage risk, increase returns, or, in some cases, both.Â
For example, a protective put may be used to manage downside risk on a stock position, or a covered call strategy may be used to earn income on a stock position. An investor who believes a stock will be range-bound may sell a straddle to increase returns on a stock that is otherwise trading sideways.Â
Covered calls or covered puts are examples of strategies that combine stocks and options. Covered positions are when options contracts are backed by shares underlying the option.
For example, if an investor owns 100 shares of stock XYZ and sells a call option on stock XYZ, the short call option is covered by the 100 shares of XYZ stock.
Strategies that combine stocks and options do not have to be completely covered.
For example, suppose an investor with 500 shares of stock XYZ is optimistic about an upcoming earnings report but wants to protect against an unexpected decline in XYZ’s stock price. In that case, the investor could buy two put options to offset some downside risk. Two put options would only protect 200 shares of XYZ, but this partial hedging strategy can limit a portion of the downside risk in the position if the stock price were to decline.
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