Do you understand the basics of how trading stock options work? Do you know what a call option is? How about a covered call option or what it means to buy a put? If not, stop here and go back to read my beginner’s guide to understanding how stock options work. If you think you have the basics down, read on to see a real work example of how you can use stock options to reduce the risk of loss with each of your stock trades.
Buy A Stock And Sell Covered Calls
Let’s take a look at a stock with the symbol AYRO and invest together in it. Let’s assume that it’s January 25th, 2021, and we buy 400 shares of the stock at an average cost of $7.12/share. That’s a total of $2848 invested in the stock.
How do you think we can use stock options to help reduce our risk in this investment?
One move we can make to help reduce our risk in this investment is to sell covered calls. While covered calls help us to reduce the risk of loss, they also put a cap on the maximum amount of money we can make on our investment. With that understanding, let’s head to the market and see how much we can sell covered calls for in this stock.
We go and open up the app to whatever broker we are using, whether it’s Ameritrade, Robinhood, Webull or Firstrade, and we take a look at what the call options are trading at. When we open the app and look at the options we may see something like the table below.
| Strike Price | Bid | Ask |
| $5.00 | $3.00 | $3.10 |
| $7.50 | $1.15 | $1.25 |
| $10.00 | $0.30 | $0.40 |
From the list of options above, we see that we can probably sell call options between the bid and ask price for whatever strike price we’d like. Let’s decide to go with the $7.50 strike price. We can sell 4 calls for $1.20 each, so we go ahead and do that. This maneuver will put $480 back into our accounts (remember 4 calls is the equivalent of 400 shares). So that means we have reduced our total investment in the stock by $480. Instead of having a total investment of $2848 in the stock our investment now stands at $2848 – $480 or a total of $2368.
Calculating Maximum Gain Potential
Since we sold a covered call, we have now capped the maximum gain we can get out of this investment assuming the stock price is above $7.50 by 2/19/21. To calculate the maximum gain we can get out of the stock we take the strike price we just sold covered calls at, $7.50, and we subtract that value from the price we paid for our shares which was $7.12/share.
Max gain = $7.50 – $7.12 = $0.38/share times 400 shares = $152
Our max gain is then $152 plus the $480 we got for selling calls. That leaves us at a total of $632. Our max gain for this trade if the stock is above $7.50 on February 19th, 2021 is $632.
Buying Puts To Further Reduce Risk
That leads us to the next question, how do we lower our maximum loss potential?
Right now we have $2368 invested in this stock. To reduce our maximum loss potential we can go ahead and buy puts. So once again, we’ll open up our favorite trading app and take a look at the put options for the stock.
| Strike Price | Bid | Ask |
| $5.00 | $0.25 | $0.35 |
| $7.50 | $1.30 | $1.40 |
| $10.00 | $3.80 | $3.90 |
After looking at the put options, we decide to buy puts at the $5.00 strike price for $0.30 each contract. Since we have 400 shares of AYRO stock we are going to buy 4 put contracts here costing us $120 total. But now that we have bought something, our total investment in AYRO just went up by $120. So our total investment is now $2368 plus $120 or $2488 total. This is still less than the $2848 we would have invested in the stock if we never bought puts or sold calls. You also need to be aware this transaction just reduced our max gain potential. Our max gain drops from $632 down to $512.
Calculating Maximum Loss Potential
Remember, we have made these trades on January 25, 2021. Now let’s fast forward and pretend its February 1, 2021. After the market closed on February 1, 2021, AYRO announces it no longer has any cash left to continue its operations. The company announces a bankruptcy. Can you calculate how much money you will lose on this stock? What is your maximum loss potential?
We bought ourselves AYRO puts at a $5 strike price. The puts make money for us when the price of AYRO stock goes below $5/share. ARYO just announced a bankruptcy, so let’s assume the stock is now going to open at $0.01 on February 2nd.
How much money did we just lose on our entire investment?
First, let’s calculate how much money we will make on the puts we bought for this transaction. Remember, when we buy puts we gain the right to buy shares at market value if the shares are trading below the strike price. In this example, we get to buy shares at $0.01 and sell them to someone else for $5 since we bought puts at the $5 strike price. Since the stock price is at $0.01 we will make $4.99 a contract for our puts or a total of $1996. But we did also pay $120 for the contracts so we must subtract that number out from the gain. So our total gain here is $1876. With that number in hand, we can now calculate what our maximum loss is on the stock.
Our total investment in the stock was $2488. The stock is now worth 1 cent, so we have basically lost our entire investment and are down -$2488. However, our puts made us $1876. So our total and maximum loss stands at -$2488 + $1876 = -$612. We lost $612 overall on this stock between the stock itself, the calls, and the puts. If we never sold calls or bought puts, we would have ended up losing $7.11/share on the stock or $2844. All these numbers can be calculated in advance before any trades are made. So you can go into a trade knowing exactly what your max gain and max loss potential will be and decide with each trade if the risks vs rewards are worth it for you. I’ve even put together an options trade calculator to help you better plan your next trade if you like this idea.
In the end and to reiterate, this series of trades that we made with AYRO had a maximum gain potential of $512 and a maximum loss potential of $612.