Options as Protection: Puts, Covered Calls and Collars

Most investors meet options as a gamble: a way to bet on a stock's next move with a small stake. That use is where most of the losses happen. Options were designed for something more modest: transferring risk from someone who wants to shed it to someone paid to take it. Used that way, they can put a floor under a holding you cannot or will not sell, or earn income from shares you already own. This chapter explains how options work, the three protective uses most relevant to long-term investors, what each one costs, and when simpler tools do the job better.

Options in plain terms

An option is a contract that gives its buyer a right, but not an obligation, to buy or sell an asset at a set price on or before a set date. The buyer pays the seller a price for that right, called the premium. In the US, one standard stock option contract covers 100 shares.

• A call option gives the right to buy at the set price. It gains value when the underlying price rises.
• A put option gives the right to sell at the set price. It gains value when the underlying price falls.

A few more terms appear in every discussion:

• Strike price: the set price at which the option can be used.
• Expiration: the last date the option can be used. After it, the option is worthless if not exercised.
• In the money: a call whose strike is below the market price, or a put whose strike is above it, so using it now has value.
• Out of the money: the reverse; using it now would be pointless. Most protective puts and covered calls are written out of the money.
• Exercise and assignment: the buyer exercises; the seller on the other side is assigned and must deliver or buy the shares.
• Time decay: an option loses value as expiration approaches if nothing else changes, because there is less time for a favourable move. Time decay works against the buyer and for the seller.
• Implied volatility: the market's expectation of future price swings, built into the premium. When markets are fearful, implied volatility and premiums rise, so protection costs most exactly when people want it most.

The buyer's loss is limited to the premium. A seller's loss depends on the position: a seller who owns the shares (covered) has a defined risk, while a seller of calls without the shares (naked) has unlimited risk. That distinction is why brokers require an application and grant different approval levels for different strategies.

Protective puts: insurance on a holding

Buying a put on shares you own sets a floor. If the price falls below the strike before expiration, the put rises in value to offset the loss, so your worst outcome is roughly the strike price minus the premium you paid. If the price rises, you keep the gain, less the premium.

This is genuine insurance, and like all insurance it is worth considering when a loss would do real damage. Common cases:

• A concentrated position you cannot sell yet, such as company stock during a lock-up or shares with a very large unrealised gain you want to hold until a lower-tax year.
• A known date when you need a sum, such as a house purchase or the first year of retirement, with too much of that sum still in stocks.
• A temporary risk you can name and date, rather than a general worry about markets.

The cost is the problem. Puts that offer meaningful protection often cost a few percent of the position's value per year when bought repeatedly, and more in fearful markets. Insuring a whole portfolio permanently this way is expensive.

If a portfolio of $200,000 grows at 7.0% a year for 20 years, it reaches about $773,937. Spending 2.0% of it every year on puts, and assuming they never pay out, it reaches about $530,660: a cost of about $243,277. In years with a crash, the puts would pay back part of that. Over long periods, the research consensus is that permanent put protection has cost more than it returned, which is why most long-term investors manage risk through their stock and bond mix instead.

Covered calls: income from shares you own

Selling a call on shares you already own earns the premium immediately. In exchange, you agree to sell your shares at the strike price if the buyer exercises. The trade-off is simple to state:

• If the price stays below the strike, the option expires worthless and you keep the premium and the shares.
• If the price rises above the strike, your shares are likely to be called away at the strike. You keep the premium and the gain up to the strike, but miss everything above it.
• If the price falls, the premium cushions the loss a little, but you bear almost all of it.

A covered call therefore gives up the best outcomes in exchange for a modest, steady income, while leaving the worst outcomes almost untouched. It suits a holder who would be content to sell at the strike anyway, and who values income over the chance of a large rise. Funds that sell covered calls on an index follow the same logic, and their long-run returns have tended to trail the index in strong markets.

Taxes add a wrinkle in a taxable account. The premium is generally a short-term capital gain when the option expires or is closed, and if your shares are called away, you realise the gain on them, possibly in a year you had not planned. Some covered calls can also pause or reset the holding period of the shares for long-term treatment. Writing covered calls inside an IRA avoids these timing issues, where the account allows it.

Collars: protection paid for by giving up upside

A collar combines the two: you buy a protective put and pay for it, wholly or partly, by selling a covered call on the same shares. The result is a band. Below the put's strike your losses stop; above the call's strike your gains stop; in between, the shares behave normally.

Collars are a common tool for executives and employees with large holdings of one company's stock, because they can reduce risk at little or no net premium while the owner waits to sell over several tax years. They have limits: insiders face company rules and securities laws on hedging, a collar that locks in a position too tightly can be treated as a sale for tax purposes, and you give up the upside you might have been holding for.

The costs and risks to weigh

• Premiums and time decay: every bought option loses value daily if the price does not move, and most expire worthless.
• Trading costs: options have wider bid-ask spreads than shares, especially on less-traded underlying assets. The spread is a cost on each trade.
• Complexity: early assignment, dividends, and expiration-day mechanics can create surprises, including an unexpected sale of your shares.
• Leverage: a small premium controls 100 shares. Used to speculate rather than protect, that leverage turns small price moves into total losses.
• Behaviour: once set up, options invite frequent trading, which raises costs and taxes and tends to lower returns.

When options are not the answer

For most long-term investors, the best protection is structural and free: an asset mix whose worst year you can tolerate, a cash reserve so you never have to sell in a slump, and money needed within a few years kept out of stocks altogether. Near retirement, the danger is less a single crash than a crash in the first years of withdrawals; the sequence of returns risk calculator shows how much that matters for your plan, and the asset allocation calculator sets a mix you can hold through it.

Options earn their place in a narrow set of cases: a large single position you cannot yet sell, a specific dated need, or income from shares you would be happy to sell at a set price. Outside those, they add cost and complexity without adding safety.