Covered call writing trades have 2 legs: the long stock position and the short call. The collar trade adds a third leg, the long protective put. The calculations for potential trade maximum gain or loss can be confusing. This article will break down the mathematics and provide a rationalization for these computations.
The 3 legs of the collar trade
- Buy a stock in 100 share increments (long stock position, a debit)
- Sell out-of-the-money (OTM) calls agreeing to sell our shares at a price higher than current market value (a credit and placing a ceiling on the trade)
- Buy OTM protective puts allowing us the sell our shares at a known lower price (a debit and placing a floor on the trade)
- The collar trade is structured such that the short call credit and long put debit results in a net option credit (the premium generated from selling the call > the cost of the long put)
Maximum gain
This occurs when the price of the stock moves to or higher than the short call OTM strike. The maximum gain is realized when the profit earned from share appreciation of the stock moves from purchase price up to the OTM call strike. We then add in the net option credit to get the total dollar maximum return. The percentage return is calculated by dividing by the cost of the stock.
$ Max gain = (Call strike – Stock purchase price) + net option credit
% Max gain = $ Max gain/Purchase price of shares
Maximum loss
This occurs when the price of the stock moves to or lower than the long put OTM strike. The maximum loss is realized when stock value moves from purchase price down to or lower than the OTM put strike. We then add in the net option credit to get the total dollar maximum loss. The percentage return is calculated by dividing by the cost of the stock.
$ Max loss = (Put strike – Stock purchase price) + net option credit
% Max loss = $ Max loss/Purchase price of shares
Hypothetical example with the BCI Collar Calculator
Collar Calculations Using the BCI Collar Calculator
In the screenshot above, if BCI is purchased at $83.32 and the call strike is $84.00 (option credit of $3.16) while the put strike is $77.50 (option debit of $1.26), the calculations are as follows:
Max gain:
- Stock gain ($84.00 – $83.32) = $0.68
- Option net credit: ($3.16 – $1.26) = $1.90
- Net position ($0.68 + $1.90) = $2.58
- On a cost-basis of $83.32 = 3.10%
Max loss:
- Stock loss ($77.50 – 83.32) = -$5.82
- Option net credit: $1.90
- Net position: (-$5.82 + $1.90) = -$3.92
- On a cost-basis of $83.32 = -4.70%
Discussion
When calculating maximum gain or loss for our collar trades, we must have 3 data points:
- Net share gain or loss
- Net option credit
- Cost of shares
The initial trade structuring must result in a net option credit. The BCI Collar Calculator will do all the mathematical legwork for us.
For more information of the collar strategy
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Your generous testimonials
Over the years, the BCI community has been incredibly gracious by sending our BCI team email testimonials sharing stories as to what our educational content has meant to their families. Moving forward, we have decided to share some of these testimonials in our blog articles. We will never use a last name unless given permission:
Hi Alan,
I’ve been a BCI member for about 3 months. I was already comfortable with the technical and fundamental side of stocks. For me learning options was a different animal, I couldn’t grasp the concept easily. I tried studying a few other online teachers and was ready to give up when someone suggested your site. I spend 15-20 hours a week reading your books and online streaming. You have a lot of material to learn from which is great, but a person has to put in the time to study. The end of Feb. or beginning of March, I will be ready to make my first option trades. I’m very excited but wish markets were better. So, thanks to your style of clarity and teaching, options make a lot of sense to me now. Keep teaching so we can keep learning.
Stan
Upcoming events
1.Mad Hedge Summit: Free Zoom presentation
Tuesday March 15th at 11 AM ET
Selling Cash-Secured Puts: 4 Practical Applications
Selling cash-secured puts is a low-risk option-selling strategy which generates weekly or monthly cash-flow. This presentation will detail how to craft the strategy to multiple applications which will align with various goals and personal risk-tolerances. Topics included in the webinar include:
- Option basics
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- Traditional put-selling
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Real-life examples along with rules, guidelines and calculations are included in this presentation.
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Selling cash-secured puts is a low-risk option-selling strategy seeking
to generate cash-flow with capital preservation in mind. This
presentation will highlight an ultra-low-risk path to option-selling
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3.Long Island Stock Investors Meetup Group
Stock Options: How to Use Implied Volatility to Determine Strike Selection
Creating 84% probability successful trades for covered call writing and selling cash-secured puts
Wednesday April 13, 2022
7:30 PM ET – 9:30 PM ET
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May 10th – 11th
Registration link to follow.
2 presentations:
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How to master all aspects of this low-risk option-selling strategy
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Market tone data is now located on page 1 of our premium member stock reports and page 1 of our mid-week ETF reports.
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Hi Alan,
I was just wondering, do you have a few relatively safe bear market strategies?
Thanks,
Sam
Sam,
Glad to help.
Below is a screenshot of a file listing bear market strategies detailed in our educational material. It includes the topic of this week’s blog article.
CLICK ON IMAGE TO ENLARGE & USE THE BACK ARROW TO RETURN TO BLOG.
Alan
Hi Alan,
I have a question about the mid-contract unwind strategy.
Do you advocate unwinding a deep ITM position in the 2nd half of a contract cycle? If yes, and there are no viable new trades (not enough time value) for the current month, what should I do? My thoughts are that I could hold the cash until the start of the next cycle, or open a new trade early that expires the following month.
I would appreciate your thoughts!
Sincerely
Salim
Salim,
The guideline for the mid-contract unwind exit strategy is to consider closing both legs of the trade if we can generate at least 1% more than the time-value cost-to-close.
We use the “Unwind Now” tab of the Elite or Elite-Plus Calculators to assist in these decisions.
If we cannot generate favorable net option credits, we take no action and continue to monitor the trade through contract expiration.
Exit strategy opportunities can occur at any time. Although this strategy is generally reserved for early-to-mid-contract, there are times we can implement MCU later in the contract as I detailed in this publication:
https://www.thebluecollarinvestor.com/mid-contract-unwind-exit-strategy-at-the-end-of-a-contract/
Alan
Premium Members,
This week’s Weekly Stock Screen And Watch List has been uploaded to The Blue Collar Investor Premium Member site and is available for download in the “Reports” section. Look for the report dated 03/04/22.
Also, be sure to check out the latest BCI Training Videos and “Ask Alan” segments. You can view them on The Blue Collar YouTube Channel. For your convenience, the link to the BCI YouTube Channel is:
http://www.youtube.com/user/BlueCollarInvestor
Best,
Barry and The Blue Collar Investor Team
barry@thebluecollarinvestor.com
Alan,
I would like to ask a general question: when prior to the expiry of an option is the best time to roll out / buy back?
The above question is prompted by my experience last week. I have sold cash secured puts for the following 3 underlying:
NVDA – 225 put 03/04
SQ – 105 put 03/04
QQQ – 335 put 03/04
As it turned out, all of the above underlying were hovering on Friday 03/04 around the strike prices of the puts I sold. I had a difficult time estimating if they finish out-of-the-money or in-the-money. Should I wait until the close of the market hoping they will expire worthless and risking being exercised (pretty desperate and dangerous – I think I answered my own question)?
Or buy back / roll out, even though the premium is still high, as they are trading at-the-money (one of my at-the-money puts still had approx. $0.30 to $0.40 of time value just half an hour before the market close – at this stage I believe it was more “speculation value” than “time value”)?
What would be your recommendation for such at-the-money scenarios: buy back / roll out towards the end of the trading on Friday, during the day, at the open on Friday, or perhaps even before Thursday’s close?
Your advice will be greatly appreciated.
Regards,
Marek
Marek,
I generally reserve rolling an option to expiration Friday, a couple of hours prior to 4 PM ET. This is when the time-value cost-to-close is at its lowest.
If we decide that we absolutely do not want to take possession of the underlying security and the share price is hovering around the strike price, we must buy back the short put. There is no way to guarantee that the strike will expire OTM. At that point, we can either roll the option or use the, now freed-up, cash to secure a different put underlying for the next contract cycle.
Here is a link to a podcast I produced on this topic:
https://www.thebluecollarinvestor.com/bci-podcast-53-itm-cash-secured-puts-allow-exercise-or-roll-the-option/
Alan
Good morning Dr. Ellman,
With everything going on in Ukraine, the markets seem to have to digest more and more bad news – higher oil, potential oil supply shortfalls if Russian oil is cutoff, higher raw materials cost for everything, humanitarian crisis, etc.
You’ve stated in both of my books on Calls and Puts to favor slightly ATM and ITM strikes in a bear market. Well, this market feels bearish to me. But would you also recommend shorter holding periods than the standard one month option contract period?
Just curious.
George
George,
Trading in volatile market conditions is challenging and not for all investors. The Ukraine tragedy is impacting the market in a big way despite much of the economic and corporate news being positive.
That said, for those of us who remain active in the market, there are many defensive approaches we can take advantage of. Here are some:
Deep ITM calls
Deep OTM puts
PCP (put-call-put or wheel) strategy
Collar strategy
Ultra-low-risk Delta strategy
Ultra-low-risk implied volatility strategy
Use of more conservative underlying securities (lower implied volatility)
Recently, I rolled-down several of my positions having had the 20% BTC limit orders executed. I even managed a couple of “doubles” like the XLP example shown in the screenshot below (note the classic V-shaped pattern).
I have multiple option-selling portfolios. Most are dedicated to monthlys; a few to weeklys. Those remain intact regarding the expiration time-frames.
Alan
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Premium members:
This week’s 4-page report of top-performing ETFs and analysis of the top-performing Select Sector SPDRs has been uploaded to your premium site. One and three-month analysis are included in the report. Weekly performance has also been incorporated into the report although not part of the screening process. Weekly option availability and implied volatility stats are also incorporated.
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Alan and the BCI team
This week’s ETF Report identifies 29 ETFs that, not only have out-performed the S&P 500 in the last 1- and 3-month timeframes, but also are positive in the last 1-month.
Alan