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Protective Puts: Using The Collar Strategy During Volatile Markets

As safe a strategy as covered call writing is there is some risk; the risk is in purchasing the stock, not in selling the option. For this reason, some investors who sell covered calls also buy protective puts to alleviate some of the risk especially in volatile markets like we’ve experienced recently. Remember, the owner of a put option has purchased the right, but not the obligation, to SELL 100 shares of the underlying stock at the strike price on or before expiration Friday. A put option is considered in-the-money if the strike price of the put option is higher than current market value of the underlying stock. Likewise, a put option is considered out-of-the-money if the strike price of the put option is lower than the current market value of the underlying equity. You will note that the in-the-money and out-of-the-money strike/share value relationships are opposite for calls and puts.

A protective put is a put option that is purchased for an underlying stock that is already owned by the put buyer. It defends against a decrease in the share price of the underlying security. When a protective put is used in conjunction with covered call writing, the strategy is referred to as a collar strategy. A collar is the simultaneous purchase of a protective put option and the sale of a covered call option. In a true collar strategy, the puts and calls are both out-of-the-money and have the same expiration dates and an equal number of contracts. Thus, we sell an out-of-the-money call and add additional downside protection for the underlying equity by purchasing a protective put option.

Example of a Collar
• Buy 100 shares of XYZ @ $48
• Sell 1 $50 (O-T-M) call option for $2
• Buy 1 $45 (O-T-M) put option for $1
• Net gain on the option buy and sale is $100 ($200 – $100)
• This brings our cost basis down to $4700 ($4800 – $100)

Possible outcomes
- Outcome if stock price surpasses the $50 strike price:

Shares are sold for $5000 ($50 strike price x 100 shares)
Results in a profit of $300 ($5000 – $4700)
ROO = 300/4700 = 6.4%

- Outcome if stock prices falls below the $45 put strike price to $43:

Shares are sold for $4500 (not $4300) because of the protective put
Net loss is $200 ($4700 – $4500) = (-) 4.3%

- Outcome if stock price remains @ $48:
ROO = $100 ($100/$4700) = 2.1%

The chart below depicts the risk profile and possible outcomes of the collar for this particular example:

 

Protective Puts

Risk-reward profile for the collar strategy

 

As demonstrated in the chart above, the profit potential of an otherwise normal covered call position (dotted line) is muted due to the additional cost of purchasing the protective put (solid line); however, the protective put also gives us downside protection at the strike of the put. If you exit the covered call position early, you can sell the remaining protective put, thus slightly improving your return.

Here is an options chain for EBAY, a stock on our current Premium Watch List showing possible call and put selections for the collar strategy:

Selections for the collar strategy

Possible call and put choices for an EBAY collar

Conclusion:

The use of protective puts when covered call writing will decrease downside risk but also result in a lower initial premium return. The collar strategy is particularly useful in volatile or bearish markets. There are other strategies that can be executed during volatile market conditions. These are detailed in the BCI Emergency Management Report located the “resources/download” section of the premium site.

Live in the Chicago area?

I will be the keynote speaker on Saturday November 10th:

AAII Chicago Chapter:

http://www.aaii.com/chapters/meeting?mtg=2227&ChapterID=1

Market tone:

The pattern of mildly positive economic reports continued this past week:

  • On Wednesday the Federal Reserve’s press release called the economy expanding at a modest pace
  • The GDP rose back to the 2% pace we saw in the first quarter
  • Most of the GDP improvement came from the all-important consumer spending
  • New home sales rose by 5.7% over the August pace and 11.7% higher than September, 2011
  • Home inventories declined to the lowest level since 2005
  • The median sales price of homes in September was 11.7% higher than in September, 2011
  • The Fed reiterated its intention to keep short-term interest rates between 0% and 0.25% at least through mid-2015
  • New orders for manufactured goods rose 9.9% in September

For the week, the S&P 500 fell by 1.5% for a year-to-date return of 14%, including dividends.

Summary:

IBD: Market in correction

BCI: Despite the favorable economic reports, the disappointing earnings and market volatility dictates taking a defensive posture favoring in-the-money strikes, low-beta stocks and ETFs. Less experienced investors should consider keeping at least a percentage of their portfolios in cash until volatility subsides.

East coast members please stay safe as the storm passes.

My best to all,

Alan (alan@thebluecollarinvestor.com)

www.thebluecollarinvestor.com

 

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About Alan Ellman

Alan Ellman loves options trading so much he has written three top selling books on the topic of selling covered calls alone. He is a dentist by day, a personal trainer, successful real estate investor, but he is known mostly for his profound stock option strategies.

10 Responses to “Protective Puts: Using The Collar Strategy During Volatile Markets”

  1. Barry B October 27, 2012 9:36 pm #

    Premium Members,

    The Weekly Report for 10-26-12 has been uploaded to the Premium Member website and is available for download.

    Also, be sure to check out the latest BCI Training Videos and “Ask Alan” segments. You can view them at The Blue Collar YouTube Channel. For your convenience, the BCI YouTube Channel link is:

    http://www.youtube.com/user/BlueCollarInvestor

    Since Earnings Season is in full swing right now, be sure to read Alan’s article, “Constructing Your Covered Call Portfolio During Earnings Season”. You can access it at:
    http://www.thebluecollarinvestor.com/constructing-your-covered-call-portfolio-during-earnings-season/

    Best,

    Barry and The BCI Team

  2. Saul October 28, 2012 6:40 am #

    Alan,

    Thanks for another informative article. I have a question about page 192 of your Encyclopedia book. You say “I like to see an OI of at least 100 contracts and/or a bid-ask spread of 30 cents or less” Why is there is no mention of volume? Thanks again.

    Saul

    • Alan Ellman October 28, 2012 3:42 pm #

      Saul,

      I view OI as a more reliable stat in determining option liquidity than is volume. This is because OI is cumulative and volume stats are reset each day. Since OI is in a constant state of flux, we do NOT publish this figure in our premium reports as we don’t want to eliminate an equity/option combination based on a number that can change day-to-day. OI should be checked at the same time you are accessing the bid-ask spreads from any options chain.

      Alan

  3. Mary October 28, 2012 4:13 pm #

    Alan,

    Numbers aren’t my strength but I’m getting the hang of these calculations and the ellman calculator. Can you confirm these numbers for gdxj from the etf list.

    price 23.43
    23 november option is 1.10
    roo=2.9% 3 weeks
    downside= 1.8%
    breakeven is 22.33

    Thanks a lot.

    Mary

    • Alan Ellman October 29, 2012 1:44 pm #

      Mary,

      Your calculations are perefect! Keep up the good work.

      Alan

  4. Steve Z October 28, 2012 4:46 pm #

    Alan, I have thought about collars off-and-on for some time but have never used them. Your article is giving me another opportunity to think about them and I have a question, albeit a not very well thought through question.

    My biggest problem with covered calls has been the times when the stock price makes an unexpected fall. “Every” month I manage to pick the one that does this. So I’ve thought about how to manage this risk.

    Let’s say we modified the BCI methodology to reduce downside risk by “always” using a collar. And let’s further say that as a trade-off for reducing the downside risk we were willing to target the lower end of the BCI methodology target monthly ROR range, e.g., 2%/month.

    By using a collar we know the max loss, max gain, and with the deltas we also know the probabilities of the stock price finishing OTM on each side of the collar. Would this give us enough information to calculate the probability of say a 2% return?

    If yes, then I’m wondering if there would be another tab in the Ellman calculator that could be created that would use the call and put price along with their associated deltas to calculate the probability of getting the 2% return.

    The beauty of this is one could pick strike prices based on statistics rather than simply going ITM or OTM based an educated guess of the market direction. Plus, it would define and limit the downside risk.

    Thoughts?

    Steve

    • Alan Ellman November 2, 2012 10:43 am #

      Steve,

      The use of collars certainly has its appeal when it comes to avoiding catastrophic losses. It is also a sensible approach for low-risk tolerant investors and in voltile market conditions. Your concept of adding collars to the calculator and perhaps factoring in deltas is interesting and actually something we have been discussing (the delta concept adds a new dimension). I have already made a note of it to discuss with my team (need the lights on first!).

      We appreciate member suggestions like yours and as a result have a list that we will address and perhaps incorporate into the BCI methodology. These ideas will ultimately make us all more successful investors.

      Alan

  5. Alan Ellman October 29, 2012 1:46 pm #

    All members:

    We are in the midst of a huge hurricane here in NY so please understand if our on and offline responses are delayed. Please stay safe.

    Alan and the BCI team

  6. Alan Ellman October 31, 2012 8:01 am #

    BCI Power update:

    We have none. Our repsonses to on and offline inquiries will be swift once power returns (what a mess!). Hope you are safe and well.

    Alan and the BCI team

  7. The BCI Team October 31, 2012 8:27 am #

    Running list stocks in the news: DDD:

    On October 25th 3D Systems Corp.reported a positive 3rd quarter earnings report with earnings up 82% year-to-year and revenues up 57%. This represented a 15.4% positive surprise with a long-term projected growth rate placed @ 17.6%. 3D Systems ended the quarter with a cash balance of $184 million. Our premium “running list” shows an industry segment rank of “A” and a beta of 1.71.

    The BCI team

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