Selling Options against Futures or Cash Position
The simplest approach to implementing a covered option position involves the combination of a cash position with an option. The crux of the idea is that when a stock’s shares flatten out or get weaker in price call options can be sold to generate income.
If the stock’s price goes down the trader gains the premium, which diminishes his losses in the shares. If the price goes up the stock trader has one of two choices— buy back the option at a higher premium or give up any gains in his shares above and beyond the option strike price. The same scenario can be played out for the futures, forex, or CFD markets.
Initiating a Covered Position
Few decisions have to be made when it comes to trading covered positions in the stock market. Those people who buy stocks are automatically long-side specialists who therefore understand that they will only be selling calls. Also since there is no leverage on the stock itself it is simpler to purchase one stock option for every 100 shares of stock owned. Finally, since the option is sold as a secondary position to the actual stock shares the option strike price is not given much thought.
The ease with which covered option positions can be implemented in the stock market gives us a contrast to the difficulty that can be associated with the futures and forex markets. When it comes to putting on covered option positions in the futures market, unlike stocks, there are too many choices. Since longs and shorts are treated equally in the futures market covered positions can be implemented with puts or calls. Delta also has a larger impact on the option selling decision. The less the delta is, the more likely multiple options at the same strike price will be sold in order to match the movement of the underlying asset.
Finally, in a covered position the sold option may actually be the primary position with the futures or spot contract acting as the protective position. This makes the option strike price more important based on how much premium can be collected.
The spot forex market has one flaw that the futures market doesn’t have—lack of a true option market. Spot forex options tend to be customized contracts between the traders and the deal makers. This makes for liquidity issues and can limit the strike prices that deal makers are willing to work with. In the end, since there is no centralized exchange in the spot forex market, it is difficult for spot options to be both fairly priced and liquid enough to be realistically used in a covered option scenario. This does not mean, though, that you can’t cross trade with forex futures options to create the exact same trades.
In this section we look at two different ways to initiate a covered option position. One is an aggressive way to put on a covered position. This action, when all of the indicators are pointing one way and a covered option is intentionally initiated in the opposite direction, is known as fading the market. The second way to initiate a covered option is when a position has already gained a profit and is stalling out. In fact, if done properly it can actually give the winning position a way to weather temporary pullbacks or retracements.
