Covered call exit strategies plays a major role in mitigating losses in our BCI methodology. In most cases, we can keep losses to a minimum, turn losses into gains and enhance profits as well. Some covered call writers want the security of protecting against a catastrophic gap-down which can occur rarely. This can be accomplished by purchasing a protective put in what is known as the collar strategy. Here’s how it works:

The collar strategy

• Buy a stock
• Sell an out-of-the-money call option (strike higher than current market value)
• Buy an out-of-the-money put option (strike lower than current market value)

Goals of this strategy

• Generate cash flow
• Protect against catastrophic price decline in the underlying security (advantage)

Disadvantages

• Lower returns
• Managing 3 positions instead of 2

Real-life example

In this article we will calculate the hypothetical returns using no puts in one case and evaluating 3 different strike prices for implementing the collar strategy with protective puts. I am using FaceBook, Inc. in this example as it has been appearing on our premium watch list for several months, has decent returns and several choices of strike prices. Here are the stats at the time I am writing this article:

FaceBook Stats on 3-11-14

Current price = $71.98

Call strike selected = $72.50

Put strikes to evaluate = $70, $68 and $66

FB options chain

 

We glean the following stats from this options chain

• Short call generates $2.80
• $70 put costs $2.16
• $68 put costs $1.46
• $66 put costs $0.94

The protective put gives us the right to sell at the strike price so the higher the strike, the greater the protection and the more expensive is the put. To determine our initial profit (ROO), we subtract the cost of the put from the cash generated from the sale of the call option ($2.80) and divide by our cost basis of $7198 per contract. From there, we can calculate returns if the share price moves above the call strike or moves below the put strikes. We will make the assumption that if no put is purchased, BCI members will employ our arsenal of exit strategies to manage our positions to maximum profits or minimum losses. Such strategies all start with buying back the option and frequently using our 20/10% guidelines as detailed in my books and DVDs. Next the calculations:

Spreadsheet using protective puts versus exit strategy management only

*Column I9 was originally published as 3.6% when it should have been 3.3%. Thanks to William for picking this up.

It is impossible to make specific final determinations using the information provided in this hypothetical because so much depends on the skill of the investor in terms of using position management when indicated as well as the amount of price decline if the put is needed. But certain generalizations of interest can be made:

Conclusions

• The initial return not using protective puts is significantly higher than when using them (ROO column)
• If the share price closes above the call strike price (>call strike column), not buying a put produces the best results (4.60%)
• If the share price closes below the put strike, the smallest losses occur for the higher strike put prices but all still result in losses
• Position management can also be used in the collar strategy but is more involved and may require more time because the investor is in 3, rather than 2, positions

Commentary

Using protective puts or the collar strategy for covered call writers is a viable and sensible approach to this strategy. However, it does have its advantages and disadvantages. The main advantage is that the call writer is protected against catastrophic share depreciation below the put strike. The main disadvantage is that the profits generated from the sale of the call option will be substantially lower due to the debit resulting from the purchase of the put. The main reason for a stock price gap-down is a disappointing earnings report and we avoid those situations in our BCI methodology. However, unexpected bad news can come out at any time. Although that scenario is rare, some investors may prefer the protection afforded by protective puts. There is no right or wrong here. Each investor must make his (her) own determinations. I personally do not buy puts but have absolutely no problem with members who do.

April seminar in Arizona (Phoenix area):

Tuesday, April 8th

Reacting to Friday’s losses:

Experienced investors tend to emotionally handle a day like Friday much better than those just starting out. Nobody likes it but days like this do happen. So what do we do? Curling up into the fetal position and feeling sorry for ourselves is unproductive. Taking appropriate action and sticking to the plan is the simple response. We buy back options that meet the 20% guideline and position ourselves to mitigate losses. We can wait a day or two and re-sell the options if prices rebound. We can also roll down to generate additional time value premium and downside protection or we can close our positions totally if we are extremely bearish (I am not but that is one man’s opinion). The question to ask is whether there is anything in the news to support a continuation of the action we saw on Friday. For me, the answer is no.

Market tone:

This week’s economic reports continued to support an expanding and healthier economy:

• According to the Labor Department, 192,000 jobs were added in March and stats for January and February were revised upward by 37,000 jobs
• 503,000 workers joined or rejoined the labor force in March causing the participation rate to rise to 63.2% from 63% as the unemployment rate remained unchanged @ 6.7%
• The US trade deficit (a report of the difference between the dollar value of exports and imports. Foreign trade is an important component of aggregate economic activity, representing a significant portion of gross domestic product. Also, the level of exports is an indicator of the global competitiveness of U.S. industries) widened in February by 7.7% to $42.3 billion, a 5-month high
• Total construction spending was up 0.1% in February compared t0o January as we recover from the severe weather conditions. Compared to a year ago, construction spending was up 8.7%
• According to the Commerce Department, orders for manufactured goods rose by 1.6% in February after declining the previous 2 months. A rise of 1.2% was projected by analysts
• The Institute for Supply Management (ISM) manufacturing index increased to 53.7 in March, an increase for the 2nd consecutive month after falling to a 7-month low in January. A reading over 50 shows expansion of our economy.
•  The ISM Non-Manufacturing Index (service sector) rose to 53.1 i9n March after declining t0o 51.6 in February

For the week, the S&P 500 was up 0.4% for a year-to-date return of 1.4%, including dividends.

Summary:

IBD: Market in correction

BCI: Cautiously bullish favoring in-the-money strikes 3-to-2

My best to all,

Alan ([email protected])

www.thebluecollarinvestor.com