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Protecting Our Covered Call Trades: Protective Puts Versus In-The-Money Strikes

Covered call writing is a low-risk, cash-generating strategy. We can lower the risk to an even greater extent by purchasing protective puts and by writing in-the-money (ITM) call options. Now, buying protective puts (called the when used in conjunction with covered call writing) costs money and will lower our returns. Using ITM calls will reduce risk but eliminate the opportunity to generate profits from share appreciation. All strategies have their pros and cons. In this article we will compare the two risk-reduction strategies using a real-life example with Centene Corporation (NYSE: CNC).

 

CNC 1-month option-chain on 4/16/2020

 

CNC Option-Chain

We will calculate the following strikes with CNC trading at $71.27:

Collar

  • OTM $72.50 call ($3.90)
  • OTM $65.00 ($2.55) and $67.50 puts ($3.20)

ITM calls

  • $65.00 ($8.50) and $67.50 ($6.80) ITM calls

 

Collar calculations with the BCI

 

CNC Collar Calculations

  • Red arrows: 1-month and annualized initial time-value returns
  • Blue arrows: 1-month and annualized returns if share price moves up to OITM call strike
  • Green arrows: 1-month and annualized returns if share price moves below the OTM put strike

 

Selling ITM call calculations with the Ellman Calculator

 

CNC Calculations with the Multiple Tab of the

  • Initial time-value returns range from 3.4% to 4.5%
  • Downside protection of those time-value returns range from 5.3% to 8.8%
  • Breakeven prices range from $62.77 to $64.47

 

Discussion

Risk reduction for our covered call trades can be accomplished in several ways. Two such approaches include buying protective puts and writing ITM call options. The former will protect against all gap-downs below the put strike but will cost money. The latter is paid for by the option-buyer in the form of intrinsic-value but will eliminate the opportunity to generate additional profit from share appreciation.

 

For more information on the collar strategy

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COLLAR CALCULATOR

 

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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 have gone through the 2 covered call books and the DVD set. I must say excellent compilation of material. It is as simple as ABC and played out excellent. The pace of the course is just fine so that it is not overwhelming.

Best regards,

Randy

 

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Alan speaking at a Money Show event

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About Alan Ellman

Alan Ellman loves options trading so much he has written four top selling books on the topic of selling covered calls, one about put-selling and a sixth book about long-term investing. Alan is a national speaker for The Money Show, The Stock Traders Expo and the American Association of Individual Investors. He also writes financial columns for both US and International publications along with his own award-winning blog.. He is a retired dentist, a personal fitness trainer, successful real estate investor, but he is known mostly for his practical and successful stock option strategies.

34 Responses to “Protecting Our Covered Call Trades: Protective Puts Versus In-The-Money Strikes”

  1. Raam October 24, 2020 3:29 am #

    Alan,

    Good Morning and i’m really liking your trading approach with options on quality stocks. i do have one question regarding protecting from an event leading to a dramatic drop (>10% in days or week) for the core stocks/etfs like during march covid times.

    assuming i have a set of ETFS and DJ30 stocks in my options portfolio, what would be suggested sell rules for the underlying ETF/Stock during any sharp drop (During the day). trying to prevent a massive down movement happening swiftly over a few days or week.

    Any recommendations on when to get out / step aside on the underlying stock/ETF. as waiting for all technicals (20,100EMA and slow stoch) might cause some pain and lots of gains to vaporize.

    Appreciate the guidance and happy weekend to you and thanks for the education/valuable service you offer.

    Regards
    Raam

    • Alan Ellman October 24, 2020 7:28 am #

      Raam,

      Here are considerations for protecting against substantial price declines:

      1. Always have our 20%/10% guidelines in place after entering our covered call trades.

      2. Protective puts can be added for additional security.

      3. Exit the stock when it is significantly under-performing the S&P 500.

      4. A price decline threshold can also be used to sell a stock, typically when share price declines 7% – 8% from when the trade was initiated.

      ***If our 20%/10% thresholds are reached and the short call is closed, there are other exit strategy opportunities to consider besides selling the stock. Position management must be mastered before entering our trades and congratulations to you for asking these important questions.

      Alan

  2. Alan K October 24, 2020 4:12 am #

    Hello Alan,

    I started paper trading the BCI CCW system entering 7 positions this past Monday.

    My question is how do you track the position in the “Multiple” tab once you BTC the short Call leg? Do you just change the “Option $/sh” value from what was received when the CC position was opened to the 80% level captured when BTC was executed and then wait to enter a new line in the tab for a new position if a Double is hit?

    Also, since I’m in a 2 week expiration period due to the 10/30 expiration, would the new STO premium I would be looking for to hit the Double be half the premium originally received or would it always be close to the same original value?

    Thank you for your input and guidance,
    Alan K

    • Alan Ellman October 24, 2020 7:35 am #

      Alan,

      Yes, you’re on the right track. here is a link to an article I published on this topic:

      https://www.thebluecollarinvestor.com/using-the-ellman-calculator-to-monitor-hitting-a-double-results/

      If and when we re-sell the option, it will frequently be for a lower price than the initial time-value premium. This is due to Theta, or time-value erosion. A guideline range would be between 25% and 75% of the original time-value. The earlier in the contract, the greater the additional premium opportunity.

      Alan

    • MarioG October 26, 2020 12:11 am #

      Trading experiences 10/25/20:

      Alan K.

      Setting the STO premium for Hit Double:
      For setting the STO premium value, I also look at what the current premium for an ATM strike at the current moment to get an idea of what the premium value will be at your strike value. Then I set an STO Limit order for your estimated value. That way you can take advantage of a price gap up of your underlying and fill the trade without your need to monitor it. If the price rises slowly you can adjust your limit order.

      Keeping track of your position for Gain or ROO% at any time:
      Once I place the initial trade, I find it simpler to keep track of the Breakeven point for all my positions to easily calculate the Gain or Gain% as future multiple events happen. This has simplified my life to calculate my Gain% at any time.

      For example, an ITM Covered call with stock price 52, strike 50 and ROO% = 2% and a premium of 3. ROO% = TV/Strike = 1 / 50. (the strike or 50 is your reference point for calculating your ROO% which I also call my RCB (Return cost basis). Your breakeven point is 49 (Stock price – premium). If the stock price stays above 50 at Expiration, the stock is sold at $50 and your Gain is 50-49 = 1 and Gain% = 1/50 = 2%.

      Buy Back:
      If you set an threshold for a buy back at 20% or $0.60 and it get filled, you new breakeven point is BEP (Old) + 0.60 = 49.6 (notice it increases). If the price of the stock at fill time as 48, your Gain is -1.6 (a loss) and your Gain% is -3.2% (-1.6 / 50).

      At Expiration, no other trades, stock price above 50:
      If you made no other trades, your stock is assigned and sold at 50, then your position Gain is .4 (50 – 49). Gain% = 0.8% (0.4/50).

      Hitting the double:
      If before expiration the price rises and you sell the call at the same strike with a premium of 2, your new BEP is 49.6 -2 = 47.6. If the stock price rises above 50 at expiration, your new Gain is 2.4 (50-47.6) or Gain% = 4.8%. If at expiration the call is worthless with a stock price of 49, your gain at that point in time (realized gain if you sell the stock) is 1.4 or Gain% 2.8.

      Hope this illustrates that by keeping track of the Break Even point, you can track you position easily. The above works identically for an OTM initial trade, except your Return Cost basis is now the stock price.

      Hope the above helps.

      Mario

      • Roni October 26, 2020 5:06 pm #

        Mario,

        A very good and detailed explanation.
        That’s exactly how I calculate all my positions.

        Roni

  3. Barry B October 24, 2020 9:02 pm #

    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 10/23/20.

    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 link to the BCI YouTube Channel is:

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

    Since we are in Earnings Season, be sure to read Alan’s article, “Constructing Your Covered Call Portfolio During Earnings Season”. You can access it at:

    https://www.thebluecollarinvestor.com/constructing-your-covered-call-portfolio-during-earnings-season/

    On the front page of the Weekly Stock Report, we now display the Top 10 ETFs, the Top SPDR Sector Funds, and the 4 single Inverse Index Funds. They are sorted using the 1-month performances from the Wednesday night ETF report and the prices from the weekend close.

    Best,

    Barry and The Blue Collar Investor Team

    [email protected]

  4. Nathan October 25, 2020 2:05 pm #

    Hi Alan,

    I have your book on selling cash-secured put, but I haven’t read it yet. On your recent report that was published you are focusing on selling deep OTM puts over covered calls. What advantage does deep OTM puts have over covered calls during this time.

    Thank you very much for your help!

    -Nathan

    • Alan Ellman October 26, 2020 7:07 am #

      Nathan,

      By selling deep OTM C-S puts, we purchase the shares “at a discount” should we allow the put options be exercised. If we do take possession of the shares, we can now write an ITM covered call resulting in a double layer of downside protection. I like this strategy in bear and volatile markets as we have now with COVID-19, pre-election concerns and earnings season.

      In most market conditions, I prefer covered call writing where 2 income streams can be generated when using OTM strikes.

      Alan

      • Nathan October 26, 2020 9:27 am #

        Good morning Alan,

        If the put is exercised, do you immediately get the shares? Or do you receive them the next day?

        Nathan

        • Alan Ellman October 26, 2020 12:25 pm #

          Nathan,

          The next trading day.

          Let’s say one of our short put positions is exercised today, October 26th. The OCC will settle the trade after hours if we are matched up with the holder’s exercise notice. The shares will be in our account on October 27th but will be listed “as of 10/26”

          Alan

          • Nathan October 27, 2020 5:56 am
            #

            Thank you, Alan! Looks like I need to get started on your “Selling cash-secured Puts” book!

  5. Packle October 26, 2020 4:13 am #

    Hello Aan, I have a question regarding to the “show or fill” rule. I noticed you suggest putting the limit price slightly in MM’s favor. What happens if I just choose the mid price without skewing it to MM’s favor? Does this still meet the show or fill rule? Thank you.

    • Alan Ellman October 26, 2020 7:13 am #

      Packle,

      Yes, you can try the midpoint (called “the mark”). I have found over the years, there is a greater chance of success when dropping slightly in favor of the MM. If our limit order is not accepted, the bid-ask spread will change reflecting our offer.

      Alan

  6. MarioG October 26, 2020 4:32 am #

    Marsha, Alan

    I just read the October 21 blog posts by Marsha and a reply by Alan on Implied Volatility, the Rule of 16. and average expected 1-day price change.

    So I searched in my browser for “Volatility Rule of 16” and received some very interesting links… Something new to learn every day. First time I have heard of the relationship.

  7. Marsha October 26, 2020 7:16 am #

    Thanks Mario for the suggestion. I’ll do a search for those links.

    Marsha

  8. Alan Ellman October 27, 2020 9:45 am #

    Nasdaq Stock Exchange Educational Contributor:

    I was invited to become an educational contributor to Nasdaq.com.

    Here is a link to my first published article on this site:

    https://www.nasdaq.com/articles/using-the-nasdaq-100-volatility-index-volq-in-covered-call-writing-decisions-2020-10-26

    Alan

    • Sunny October 27, 2020 12:01 pm #

      Great article, Alan.

      I plan to implement conservative strategy selling CSP on QQQ as part of my portfolio. Referring to your example, the bottom price range of $257.63 can be used for selecting CSP strikes too ($257 or $258 in given example)?

      Sunny

      • Alan Ellman October 27, 2020 12:10 pm #

        Sunny,

        Absolutely.

        Future article?

        Alan

        • Roni October 27, 2020 2:51 pm #

          Alan,

          congratulations on being invited by NASDAQ.

          I read the article and understood most of it, except for where you got the 29% number from?

          As you know, I have never traded ETFs because of the “low” returns, and therefore my question is probably naive.

          Roni

          • Alan Ellman October 27, 2020 3:57 pm
            #

            Roni,

            Great question. There was a typo when my article was being transferred to the Nasdaq site. It should read 9.29%

            Alan

        • Terry October 27, 2020 2:52 pm #

          Alan;

          In your article for the following calculation:

          “29% of $284.32 is $26.69, leaving an expected price range for QQQ between $257.63 and $311.01”

          I believe should be 9.29% instead of 29%.

          Terry

          • Alan Ellman October 27, 2020 3:54 pm
            #

            Terry,

            Great catch. I’ll let the team at the Nasdaq exchange know about this typo.

            Thanks.

            Alan

  9. Barry B October 27, 2020 11:38 am #

    BCI Community,

    I have been having technical problems with my email account. So, if I haven’t returned your email(s), please standby as we correct the issue.

    Thank you,

    Barry

  10. Randy October 28, 2020 1:43 am #

    Hi Alan!

    I’ve been thru the videos (2 times) and the two Covered Call books.

    You’ve inspired me to join in and now I am a member of the Premium Group as the list helps me for now not do the Fundamental, Technical and Common Sense analysis (saves me tons of time). For now I want to put concentrated effort on OPTION SELECTION.

    I’ve a question about entering the trade(the option selection). The near exact mechanics of entering according to the BCI methodology. I’ll state the facts and procedure as I understand:

    Postulates I know:
    • I must want to own the stock (for the time being at least when I am in the trade or if I want to use it for multiple Covered Call Writings).
    • I also understand that we need to diversify into 5 industries using a stock from each.
    Procedure for OPTION SELECTION to enter the trade (when already have stock list or have done stock selection):
    • From the given list do I preferably want to use the stocks highlighted in BOLD?
    • I plug in the numbers into the ELLMAN calculator from the OPTIONS CHAIN for the STOCKS WHITE LIST to get the numbers for 2-4% initial return.
    • Anything above 6% is a good chance to get assigned.
    • I see the difference in the spread and also if there is ER in the current cycle.
    • For BOLD ones I am trying to go OTM, ATM/NTM and for non-bold ones I am doing ITM.
    Please modify the steps for me or tell me in another simpler way so that I can look into the numbers and have confidence in placing the paper trades to perfect the BCI methodology.

    My idea is to have a near mechanical system with the spices of your experience and tad bit of my (the trader’s) common sense. Hence I am asking the near mechanical process of entering the trade.

    Best regards,
    Randy

    • Alan Ellman October 28, 2020 6:27 am #

      Randy,

      Here are my comments for your consideration:

      1. The BCI guideline is to diversify into at least 5 different stocks in 5 different industries. Less positions are required if using ETFs. This is a minimum requirement.

      2. All stocks in the white cells are eligible for option-selling as long as there is adequate option liquidity (open interest… see OI column). Many of our members do favor stocks in bold because they have all bullish chart technicals but the others should also be given serious consideration. I have non-bold stocks in my portfolios all the time and do well with most of them.

      3. My initial time-value return goal range is 2% – 4% for 1-month near-the-money strikes based on my personal risk-tolerance. I use 1% – 2% in my mother’s more conservative portfolio. Some BCI members go higher. It’s an individual preference.

      4. In bull markets, I may go as high as 6% but never higher. The reason is the risk inherent in high implied volatility stocks, not my concern over exercise.

      5. Yes, with stocks in bold, I’m more likely to favor OTM calls but overall market assessment is critical to strike decisions as well. A strong bull market may lead me to favor OTM strikes in most of my portfolio decisions, bold or non-bold.

      You’re off to a great start.

      Alan

  11. Roni October 28, 2020 9:44 am #

    Hoyt and Jay,

    We have not heard from you this week??

    Roni

  12. Alan Ellman October 28, 2020 10:32 am #

    Trade Talks Interview

    I just accepted an invitation to be interviewed by Nasdaq reporter, Jill Malandrino, on Monday November 2nd at 2 PM ET.

    Recorded on Monday November 2, 2020 at 2 PM ET

    Link will be provided after editing by Nasdaq.com

  13. Alan Ellman October 28, 2020 5:09 pm #

    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 option and implied volatility stats are also incorporated.

    The mid-week market tone is located on page 1 of the report.
    For your convenience, here is the link to login to the premium site:

    https://www.thebluecollarinvestor.com/member/login.php

    NOT A PREMIUM MEMBER? Check out this link:

    https://www.thebluecollarinvestor.com/membership.shtml

    Alan and the BCI team

  14. Joanna October 29, 2020 2:12 am #

    Alan,

    How does one create “hard cutoffs” for when to cut ones losses and get rid of a stock? Is it a percentage down, or technicals, or fundamentals?

    This is my biggest challenge…when to throw in the towel…I hate unwinding everything only to see a rebound immediately after I get out…..any suggestions for solid cutoffs?

    Thanks,
    Joanna

    • Alan Ellman October 29, 2020 5:52 am #

      Joanna,

      There are 2 guidelines in the BCI methodology as when to sell the underlying security:

      1. When price performance is significantly under-performing the S&P 500.

      2. A percentage price decline from when the trade was initiated… 7% – 8% is a reasonable threshold. We added a 7% price decline stat in our new Elite-Plus calculator as shown in the screenshot below.

      CLICK ON IMAGE TO ENLARGE & USE THE BACK ARROW TO RETURN TO BLOG.

      Alan

  15. Alan Ellman October 29, 2020 8:07 am #

    Earnings:

    There are several key earnings releases today that may impact market direction in the near-term:

    AAPL
    AMZN
    GOOGL
    FB
    SBUX

    To name a few.

    Ultimately, COVID-19 and election-related issues will write the final chapter.

    Once these matters are managed and resolved successfully, we are well positioned. With near 0% interest rates through the end of 2023 (as per the Fed), the stock market is the only game in town.

    Alan

  16. Nathan October 29, 2020 12:24 pm #

    Good afternoon Alan,

    Today my limit order purchased back my call option,and I rolled down. I used the formula you provided in the articles you published on facebook to determine the strike price to roll down to. It worked great. Thanks for the new tool!

    I like it because 1 standard deviation seems to be a good point where it’s not likely, most of the time, to be exceeded. And, at that point, there also looks to be a good return. I thought about what 2 standard deviations would give you as this would change the certainty from 68% to 95%, but my guess is the return would be very minimal at 2 standard deviations. Thanks again! Love the new tool.

    -Nathan

  17. Alan Ellman October 30, 2020 12:02 pm #

    Market decline:

    To our members who are in traditional covered call positions, please make sure all 20% guideline opportunities have been addressed.

    I am currently 80% in cash as I have reported in our member reports and on this blog having sold deep OTM puts with Deltas of 10 or less. None of those puts are currently ITM but some are getting close.

    For our members following this approach, keep in mid our 3% guidelines for share depreciation.

    I am currently extremely defensive (hence the 80% cash decision) but even more bullish regarding the market once COVID-19 and election concerns are resolved.

    With 0% interest rates through then end of 2023 likely, the opportunities will be huge… one man’s opinion.

    It is critical to remain non-emotional in these challenging times.

    Alan

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