Before any derivatives trade, write down five numbers. If you cannot fill them in, you are not evaluating a position - you are guessing.
11 min read · Level 5
Most derivatives strategies sold to individuals are ways of trading one risk for another and relabelling the result. Covered calls convert upside into income; protective puts convert a known cost into reduced downside. Both are legitimate. What I would push back on is the framing that either makes money appear from nowhere, because once the five numbers are written down, the trade-off is usually clear and often not worth it.
Every derivatives position can be reduced to five numbers:
1 Maximum loss in money, not percentage 2 Break-even the price needed at expiry to lose nothing 3 Total cost premium, spread and commissions 4 Time available days to expiry, and when decay speeds up 5 What must happen the move, by when, for this to work
Two common structures show how the numbers change.
Protective put. You own 100 shares at 100 and buy a put, strike 90, premium 2, costing 200. If the share falls to 70:
Loss on shares -3,000 Put pays (90 - 70) x 100 +2,000 Premium paid -200 Net -1,200
The maximum loss is capped at (100 - 90) x 100 + 200 = 1,200, however far the price falls. If the share never falls, you lose the 200 premium.
Covered call. You own 100 shares at 100 and sell a call, strike 110, premium 2, receiving 200. If the share rises to 130, your gain is capped at (110 - 100) x 100 + 200 = 1,200, compared with 3,000 had you just held. If the share falls to 90, you lose 1,000 on the shares, offset by 200: a loss of 800.
Because derivatives magnify the gap between having a view and having a plan. Most losses come from positions opened on a directional hunch without anyone writing down how much could be lost or what had to happen.
The five numbers also expose trade-offs that sales pitches blur. A protective put is insurance with a cost. A covered call earns income by giving away upside. Neither is free money.
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Educational, not personalised financial advice. Nothing in the Investor Academy is a recommendation to buy, sell or hold anything — what is right for you depends on your own circumstances and the rules where you live.
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An investor considers a protective put on a 20,000 holding of 200 shares at 100.
Put strike 90, premium 2, two contracts Cost 2 x 100 x 2 = 400 Share of holding 400 / 20,000 = 2.0% Days to expiry 90 Maximum loss on the position (10 x 200) + 400 = 2,400
If they rolled similar puts every quarter, the cost would be around 1,600 a year - 8% of the holding - before any payout. The investor concluded that permanent insurance at that price was too expensive, and that reducing the position size would limit risk more cheaply.
Calling a covered call strategy income without counting the upside given away, or treating a protective put as free protection without counting the premium paid every period.
If any is missing - especially maximum loss - do not open the position.
For insurance-like strategies, multiply the premium by how often you would repeat it and compare to the holding's value.
Ask whether holding less of the share, or holding cash, achieves the same risk reduction more cheaply.
Decide the price or date at which you will close the position, and write it down.
Before opening, adjusting or rolling any derivatives position.
Do not use the five-number check as a reason to trade. It is a filter that should stop most positions, not a template for making them feel safe.
Funds that systematically sell call options against their holdings have been widely marketed for income. Performance data published by index providers over long periods show such strategies generally lagging the underlying index in strong rising markets, because gains above the strikes were given away, while holding up somewhat better in flat periods.
An income figure from option premiums should always be compared with the upside surrendered to earn it.
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