As safe a strategy that covered call writing is, there is some risk…the risk is in the stock, not in selling the option. That is why some investors who utilize this strategy buy protective puts to alleviate some of the risk.
Definition of a protective put:
A put option purchased for a stock that is already owned by the owner of the option. A protective put 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 in options trading is the owning of the underlying shares while simultaneously selling the call options and buying protective puts. In a true collar strategy the puts and calls are both out-of-the-money having the same expiration dates and equal number of contracts. So we sell an O-T-M call and protect the downside by purchasing a put.
Example of a Protective Put/Collar Strategy:
- Buy 100 x Company XYZ @ $48
- Sell 1 x $50 call for $2
- Buy 1 x $45 put for $1
- Net gain on the option buy and sale is + $100 ($200 – $100)
- This brings our cost basis down to $4700 ($4800 – $100)
Outcome if stock price surpasses the $50 strike price:
- Shares are sold for $5000 (50 strike x 100 shares)
- Results in a profit of $300 ($5000 – $4700)
- ROO = 300/4700 = 6.4%
Outcome if stock prices falls below the $45 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/$4800) = 2.1%
The profit potential is muted due to the cost of the protective put but the downside risk is protected at the strike of the put. If you exit the covered call position early, you can sell the remaining protective put improving the return slightly.
Tax treatment of Protective Puts:
When the protective put is purchased on the same day as the stock, it is referred to as a married put for tax purposes. To calculate capital gains or losses, the investor adds the premium paid for the option to the purchase price of the stock to calculate the tax basis of the stock. For example, you buy 200 x ABC @ $30. On the same day, you purchase 2 x $25 puts @ 2. The tax basis of the stock is $6400 ($6000 + $400).
The case against protective puts:
Let me premise these remarks by saying that there is nothing wrong with purchasing protective puts. I feel, however, that we can get our insurance for free by educated, well-calculated and common sense investing. Here is what the Blue Collar Investor System does to alleviate risk without spending cash for insurance (protective puts):
- Select only the greatest performing stocks.
- Select equities in the best performing industries.
- Avoid earnings reports, the most likely cause of a radical share downturn.
- Avoid companies that report same store retail sales.
- Sell I-T-M strikes when market tone and/or stock technicals are compromised. In this case, the option buyer is paying our insurance.
- Use technical analysis to determine buy-sell points.
- Implement exit strategies when needed.
- Sell predominantly 1-month contracts for better control.
The only time a protective put will benefit us over and above our system’s inherent protection, is when a stock drops precipitously in a short period of time. This can occur after an earnings report but we are already avoiding these reports. Otherwise, such events are few and far between but possible. Therefore, in my judgment, it doesn’t pay to purchase a put every time you sell a call option. You’re just not getting enough bang for your buck as long as you do your due diligence and follow all the system criteria.
Premium Members 10% Discount:
Several of our newer premium members have inquired how to take advantage of the 10% discount member perk. It’s simple:
1- Login to your premium site.
2- Scroll down to the lower right side of the page.
3- Click on the link to gain access to the store.
4- A 10% discount will be credited to your account @ checkout. See the link below:
Not surprisingly, the reports were mixed but leaning more to the positive this past week:
- Industrial production fell by 0.2% in September, the biggest decline since June 2009.
- Housing starts were up by 0.3% in September but total housing permits declined by 6%.
- The Federal Reserve’s Beige Book of economic conditions found the economy growing in September and early October but at a “modest” pace.
- The Conference Board’s index of leading economic indicators increased by 0.3% in September and concluded “There isn’t any indication of a relapse into another downturn through the end of the year.”
- For the week, the S&P 500 was up 0.6% for a year-to-date return (with dividends) of 7.8%
The Golden Cross: Short term moving average moves above the long term moving average:
The Golden Cross indicates a bull market on the horizon and is reinforced by high trading volumes. Additionally, the long-term moving average becomes the new support level in the rising market. Let’s view a chart of the S&P 500 using the 50-d and 200-d simple moving averages:
Note that the shorter term 50-d sma (blue arrow) just moves barely above the longer term 200-d sma (red arrow) at the green circle. This golden cross is strengthened by recent increasing volume (black line at bottom).
IBD: Market in a confirmed uptrend
BCI: Moderately bullish selling a greater percentage of O-T-M strikes. In addition to the favorable economic reports and the positive technical patterns developing, the earnings reports have been quite strong thus far and this bodes well for the near term market. Yet to be determined is the impact the upcoming elections will have on the stock market.
My best to all,