When covered call writing is combined with protective puts the strategy is known as the collar strategy. The short call places a ceiling on gains and the long put represents a floor protecting losses. The two option positions should result in a net credit. Typically, out-of-the-money calls and puts are selected.
Covered call writing and selling cash-secured puts are low-risk option-selling strategies used to generate monthly cash flow. Low-risk does not mean no risk so how can we measure the degree of risk we are undertaking? Let’s first all agree that any strategy that aspires to generate higher than a risk-free return (Treasuries, for example) will incur some degree of risk. Portfolio managers and institutional investors focus in on market risk like a laser and use Delta in many instances to ascertain and manage market risk (also called systematic risk).
These are portfolios consisting of positive and negative Delta positions which balance out to bring the net change to zero. Institutional traders use Delta-neutral positions to eliminate market risk from their positions. For example, if 1000 shares of stock are purchased for a positive Delta of +1000 (1.00 x 1000), the trader may then purchase 20 put contracts (representing 2000 shares) with a Delta of -0.50, thereby creating a Delta-neutral position. If share value declines, put value increases.
Delta and the collar strategy
Using the option Greeks and Delta in particular, we can see how the collar mitigates risk in much the same way portfolio managers attempt to mitigate market risk in their portfolios.
The 3 components of the collar
- Long stock (Delta of +1.00)
- Short call (negative Delta)
- Long put (negative Delta)
Generally, out-of-the-money calls and puts are used.
Covered call writing (consisting of the first 2) lowers overall Delta and therefore decreases market risk. Adding in the long put further mitigates systemic risk. The disadvantage of the long put component is the cost of the put which will decrease potential returns but enhance portfolio protection.
Real-life example with Microsoft (MSFT) as of 7/21/2017
Here are the stock and option pricing as market opens on 7/21/2017:
- Stock price: $74.22
- $75.oo call price (bid): $1.54
- $70.00 put price (ask): $0.68
Portfolio Deltas for each strategy (100 shares and 1 contract of each component)
- Stock: +100
- Covered call writing: (+100 -46) = +54
- Collar: (+100 -46 -19) = +35
Maximum gains per 100 shares
- Stock: Unlimited
- Covered call writing: ($154.00 + $78.00) = $232.00 (call premium + share appreciation to strike)
- Collar: ($154.00 + $78.00 – $68.00) = $164.00 (call premium + share appreciation to strike – put premium)
Maximum loss (with no position management, a ridiculous assumption…does not apply to Blue Collar Investors)
- Stock: $7422.00 (if stock price declines to zero)
- Covered call writing: ($7422.00 – 154.00) = $7268.00 (stock price drops to zero)
- Collar: [(7422.00 – $7000.00) + $154.00 – $68.00] = (-) $336.00 (stock price drops below the $70.00 put strike price)
After entering option chain information into the white cells, the green cells become populated with the following calculations:
- Initial return: 1.16% (15.10% annualized)
- Maximum return: 2.21% (28.80% annualized)
- Breakeven: $73.36
- Maximum loss: 4.53% (59.01% annualized)
The pink cells reflect the price points to buy back the short calls to initiate our exit strategies.
Portfolio managers tend to reduce market risk by seeking Delta-neutral portfolios. By using this analogy, we can visualize the benefits of selling covered call options and buying put options after taking a stock position. A critical skill not discussed in this article is the use of position management techniques which will enhance our gains and mitigate losses.
Upcoming speaking event
Orlando Money Show: February 8th – 11th, 2018
Thursday, Feb 8, 2018
09:00 AM – 09:45 AM
All Stars of Options
“How to Select the Best Options for Covered Call Writing in Bull and Bear Markets”
Friday, Feb 9, 2018
12:15 PM – 03:15 PM
Premium Master Classes (Paid event to Money Show)
“Basics of Options Trading Using Covered-Call Writing with Pro-Active workshop”
Friday, Feb 9, 2018 06:30 PM – 07:00 PM
“Covered Call Writing with Dow 30 and S&P 500 Stocks”
- Markit manufacturing PMI for Dec. 55.1 (expansion)
- ISM manufacturing for Dec. 59.7% (expansion)
- Construction spending for Nov. 0.8% (above expectations)
- ADP Employment for Dec. 250,000 (last 185,000)
- Weekly jobless claims for week ending 12/30/17 250,000 (above expectations)
- Non-farm payrolls 148,000 (below consensus)
- Unemployment rate 4.1% (as expected)
- Trade deficit $50.5 billion (above expectations)
- ISM non-manufacturing for Dec. 55.9% (expansion)
- Factory orders for Nov. 1.3% (above expectations)
THE WEEK AHEAD
Mon Jan 8th
- Consumer credit for Nov.
Tue Jan 9th
- Job openings for Nov.
Wed Jan 10th
- Wholesale inventories
Thu Jan 11th
- Weekly jobless claims for week ending 1/6/18
- Producer price index
- Federal budget for Dec.
Fri Jan 12th
- Consumer price index
- Retail sales
- Business inventories
For the week, the S&P 500 rose by 2.60% for a year-to-date return of 2.60%
IBD: Market in confirmed uptrend
GMI: 6/6- Buy signal since market close of August 31, 2017
BCI: I have a short-term bullish approach to the market, selling 2 out-of-the-money strikes for every 1 in-the-money strike. A strong global economy, the tax plan’s favorable impact on corporations, the accommodative Fed funds rate, low unemployment and strong corporate profits all factor in to this assessment. Potential political fireworks needs to be monitored but the market has been extraordinarily resilient thus far.
WHAT THE BROAD MARKET INDICATORS (S&P 500 AND VIX) ARE TELLING US
The 6-month charts point to a bullish outlook. In the past six months, the S&P 500 was up 13% while the VIX (9.22) moved down by 17%.
Wishing you much success,
Alan and the BCI team