Selling Upside for Income or Buying Protection Against Losses

A covered call involves owning a stock and selling a call option on it, collecting a premium in exchange for giving up gains above the call’s strike price. A protective put involves owning a stock and buying a put option on it, paying a premium for the right to sell at the put’s strike price if the stock falls.

The two strategies move in opposite directions. A covered call brings in money and slightly reduces the risk of owning the stock, but caps its upside, while a protective put costs money and sharply limits the downside, but leaves the upside open.

Both are conservative strategies built on shares the investor already owns, and both appear regularly on the exam. For the full route from the exam to a career advising on these strategies, our complete guide to how to become an investment adviser representative covers every step.

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How a Covered Call Works

In a covered call, the investor owns at least 100 shares and sells one call option for each 100 shares. The buyer of the call pays a premium for the right to buy the shares at the strike price before expiration.

If the stock stays below the strike price, the call usually expires worthless and the investor keeps both the shares and the premium. If the stock rises above the strike, the shares are likely to be called away at the strike price, and the investor misses any gain above it.

The call is covered because the investor owns the shares needed to deliver if the option is exercised. That is the key difference from an uncovered call, which carries unlimited risk, as explained in our article on what maximum risk an uncovered call writer faces.

How a Protective Put Works

In a protective put, the investor owns the shares and buys one put option for each 100 shares. The put gives the investor the right to sell the shares at the strike price before expiration, whatever the market price.

If the stock falls below the strike, the investor can exercise the put or sell it for its value, limiting the loss. If the stock rises, the put expires worthless, and the investor’s only cost is the premium paid.

A protective put works like insurance on a share position. The Series 65 Exam Preparation course at FRC covers both strategies, including the breakeven and maximum gain and loss calculations the exam asks for.

Covered Call and Protective Put Compared

Worked Example: A Covered Call

An investor buys 100 shares at $50 and sells one call with a $55 strike for a premium of $2 per share, or $200. Step one: the breakeven is $50 minus $2, or $48 per share.

Step two: the maximum gain is the strike of $55 minus the cost of $50 plus the $2 premium, or $7 per share, a total of $700, reached if the stock is at or above $55 at expiration. Step three: the maximum loss is the cost of $50 minus the $2 premium, or $48 per share, a total of $4,800, if the stock falls to zero.

At expiration, if the stock is at $60, the shares are called away at $55 and the investor makes $700. At $50, the call expires and the investor keeps the $200 premium; at $40, the investor loses $1,000 on the shares, partly offset by the premium, for a net loss of $800.

Worked Example: A Protective Put

An investor buys 100 shares at $50 and buys one put with a $45 strike for a premium of $1.50 per share, or $150. Step one: the breakeven is $50 plus $1.50, or $51.50 per share.

Step two: the maximum loss is the cost of $50 minus the $45 strike plus the $1.50 premium, or $6.50 per share, a total of $650, however far the stock falls. Step three: the maximum gain is unlimited, reduced only by the $150 premium.

At expiration, if the stock is at $60, the investor makes $1,000 on the shares minus the $150 premium, a net gain of $850. At $50, the put expires and the investor loses the $150 premium; at $40, the put limits the loss to $650 instead of $1,000.

Study Options Strategies With FRC

Options questions on the exam often describe a strategy and ask for its breakeven, maximum gain or maximum loss, or describe an investor’s goal and ask which strategy fits. Our Series 65 course teaches a simple method for each calculation, with worked examples and practice questions.

Consider studying with FRC for every exam on your route. Explore our USA exam courses, from the SIE through the Series 7, Series 63 and Series 65.

To take advantage of the membership, explore FRC Professional Membership, which gives you a verified Digital Profile that shows employers your real-time course progress, together with the Video Resume. Current offers are on our membership deals page.

Measuring a Covered Call’s Return

Covered call writers often look at two returns: the return if the stock is unchanged and the return if the shares are called away. Both are measured against the cost of the shares.

Worked example: using the earlier position, the investor bought shares at $50 and sold a three-month $55 call for $2. Step one: if the stock is unchanged at expiration, the return is $2 divided by $50, or 4 percent for three months. Step two: if the shares are called away at $55, the return is $5 of gain plus $2 of premium, divided by $50, or 14 percent for three months.

These figures look attractive, but they come with the cost of capped upside and full exposure to a fall. Advisers should present both alongside the maximum loss so clients see the whole picture.

Choosing the Strike Price

For a covered call, a strike close to the current stock price brings a larger premium but a greater chance the shares are called away. A strike well above the current price brings a smaller premium but leaves more room for the stock to rise.

For a protective put, a strike close to the current price gives more protection but costs more. A strike well below the current price is cheaper, but the investor absorbs more of the loss before the protection starts.

Time to expiration matters too. Longer-dated options carry higher premiums, which helps the covered call writer but costs the protective put buyer more.

The Collar: Combining Both Strategies

A collar combines a covered call and a protective put on the same shares. The premium received from selling the call helps pay for the put, and sometimes covers it completely.

Worked example: using the same shares bought at $50, the investor sells the $55 call for $2 and buys the $45 put for $1.50, a net credit of $0.50 per share. Step one: the maximum gain is $55 minus $50 plus $0.50, or $5.50 per share, $550 in total. Step two: the maximum loss is $50 minus $45 minus $0.50, or $4.50 per share, $450 in total.

Step three: the breakeven is $50 minus the $0.50 credit, or $49.50. The collar locks the outcome within a range, which suits investors who want to protect a large gain without paying much for the protection.

Who Each Strategy Suits

A covered call suits an investor who expects the stock to stay flat or rise modestly and wants extra income from shares they already own. It is common among income-focused investors and in some retirement accounts, where the premium is not taxed when received.

A protective put suits an investor who wants to keep a stock for its upside but is worried about a sharp fall, for example before an earnings report or after a large run-up. It is often used to protect a concentrated position the investor does not want to sell for tax reasons.

Neither strategy suits every client. Advisers must consider the client’s objectives, experience with options, tax situation and ability to bear losses before recommending either one.

Tax Points to Know

Premiums received from selling calls are not taxed when received. They are taxed when the option expires, is bought back or is exercised, and if the shares are called away, the premium is added to the sale proceeds.

Some covered calls can affect the holding period of the underlying shares, depending on how far in the money the call is written. Buying a put on shares held for one year or less can also affect the holding period for long-term capital gains purposes.

Advisers should review these rules with the client’s tax professional before using options on shares with large unrealised gains. A strategy that looks sensible before tax can be less attractive once the tax effect is included.

Protective Puts and Stop-Loss Orders Compared

Some investors use a stop-loss order instead of a put, telling the broker to sell if the price falls to a set level. A stop-loss costs nothing upfront, which makes it seem cheaper.

The difference appears in a sudden fall. A stop-loss becomes a market order once triggered, so if the stock opens far below the stop price after bad news, the shares may be sold well below the intended level, while a put guarantees the right to sell at its strike price whatever the market does.

A stop-loss can also be triggered by a brief dip, selling the shares just before they recover. A put leaves the investor in control, because exercising it is a choice, not an automatic order.

Using These Strategies in Retirement Accounts

Many IRA custodians allow covered calls and protective puts, because neither strategy requires borrowing or creates unlimited risk. Uncovered options, by contrast, are generally not permitted in IRAs.

Inside an IRA, option premiums and gains are not taxed when they occur, which removes the holding-period complications that apply in taxable accounts. The trade-off is that losses cannot be deducted either.

Firms must approve clients for options trading before they use either strategy, based on the client’s experience, objectives and financial situation, and must provide the options disclosure document. Advisers should confirm that approval is in place and suitable for the account.

Risks and Trade-Offs

The main risk of a covered call is the loss of upside. If the stock jumps well above the strike, the investor watches the gain go to the call buyer, and still bears almost all of the downside if the stock falls.

The main cost of a protective put is the premium. Buying protection repeatedly can reduce returns substantially over time, just as paying insurance premiums year after year adds up.

Both strategies involve option contracts that expire, so the investor must decide what to do at each expiration. Our comparison of call option vs put option explains the rights and obligations behind each contract.

The Memory Aid

Remember “covered call collects, protective put protects”: the covered call brings in income, the protective put buys insurance.

For breakevens, remember “call cuts the cost, put pushes it up”: for a covered call, breakeven is cost minus premium, and for a protective put, it is cost plus premium.

For the trade-off, remember “call caps the top, put puts in a floor”.

Exam Traps to Avoid

The first trap is saying a covered call has unlimited risk. That applies to an uncovered call; a covered call’s maximum loss is the stock’s cost minus the premium.

The second trap is adding the premium to a covered call’s breakeven. The premium received lowers the breakeven.

The third trap is assuming a protective put caps the upside. It does not; only the premium reduces gains. The fourth trap is forgetting that a covered call still leaves the investor exposed to almost all of the downside of the stock.

A Client Scenario

A client holds 2,000 shares of a technology company bought years ago at $20, now worth $150, making up 40 percent of her portfolio. She is worried about a fall but does not want to sell, because she would owe a large capital gains tax.

The adviser explains that a protective put would limit her losses but could be expensive on a volatile stock, while a covered call would bring in income but offer little protection. A collar, selling an out-of-the-money call to help pay for an out-of-the-money put, could protect most of her gain at a low net cost.

The adviser recommends discussing the collar’s tax effects with her tax professional and gradually reducing the position over several years. The recommendation, the risks of each strategy and the client’s options experience are documented in her file.

The Dictionary as a Video Library

The FRC dictionary is a study tool, not just a glossary. Every entry pairs a written explanation with deep-dive video, on-page quizzes and interactive flash cards, so you can read a concept, watch it explained and test yourself in one place.

Rules are covered in the same depth: open a rule and you will find the full explanation alongside video walk-throughs of how it applies in practice. Open the covered call and protective put entries to see each payoff worked through on video and test yourself with the quizzes.

Practice Questions to Test Yourself

Question one: An investor buys a stock at $40 and sells a $45 call for $3. What is the breakeven? $37, the cost minus the premium.

Question two: In the same covered call, what is the maximum gain per share? $8, the $45 strike minus the $40 cost plus the $3 premium.

Question three: An investor buys a stock at $60 and buys a $55 put for $2. What is the maximum loss per share? $7, the $60 cost minus the $55 strike plus the $2 premium.

Question four: In the same protective put, what is the breakeven? $62, the cost plus the premium.

Question five: Which strategy limits downside without capping upside? A protective put.

Turn Options Knowledge Into Career Evidence

Advisers who can explain option strategies simply help clients use them safely, and firms value that skill. FRC’s Digital Profile shows employers the courses you are actively studying and the progress you have earned through assessed learning, verified by FRC, and a QR code on your resume takes them straight to it.

The FRC Video Resume lets a hiring manager hear you before the interview. Walking through how a collar protects a concentrated position shows the practical judgment wealth management firms look for.

Related Questions

Option strategies can change the holding period of the shares involved, which affects whether gains are taxed at short-term or long-term rates, as explained in Short-Term vs Long-Term Capital Gains.

Key Points to Retain

A covered call combines owning shares with selling a call, earning a premium but capping gains at the strike price; its breakeven is the stock’s cost minus the premium and its maximum loss is the cost minus the premium. A protective put combines owning shares with buying a put, limiting losses for the cost of the premium; its breakeven is the stock’s cost plus the premium and its upside is unlimited.

A collar combines both, using the call premium to help pay for the put and locking the outcome within a range. Advisers choose between these strategies based on the client’s outlook, objectives, tax position and options experience.

For the role the exam leads to, read our guide to what an investment advisor representative is.