Using covered calls and puts in a conservative manner can benefit us in so many ways. In this article I will present a method to protect stocks in our portfolio that have increased in value substantially since they were purchased. We will utilize both covered call writing and protective puts which is known as the collar strategy.
Components of a collar
- Own 100 shares of the underlying security (stock or exchange-traded fund) per contract
- Sell (usually) an out-of-the-money call option
- Buy (usually) an out-of-the-money put option
- The net premium can be a debit, credit or break even
Why use a collar?
The advantages of a collar are the downside protection afforded by the put ownership (giving us the right to sell at the strike price no matter how low the price drops) and the share appreciation potential from current market value up to the call strike price (but not beyond the strike price). The disadvantage, of course, is the cost of the protective put.
What is a zero-dollar collar?
This is a collar where the premium generated from the call option is equal to or nearly the same as the cost of the put premium resulting in a low-cost or no cost scenario on the option side. If this can be accomplished, we can then benefit from the advantages stated above at little or no cost. This strategy can be particularly useful for those trading with securities that were purchased at significantly lower prices than current market value. As an example, I have selected Helen of Troy Ltd. (HELE) a stock on our Premium Watch List at the time I am writing this article. Here is a one-year chart showing the price nearly doubling in that time frame (yellow field highlights share appreciation):
We can opt to protect the huge appreciation by buying a put but that will result in a net debit in our account. We can also elect to sell half the shares and play with “house money” but here we are reducing our position on one of our best-performers. Another approach is the zero-dollar collar. Let’s have a look at the options chain on 10/13/2015 and view the five-week November expirations to see if we can locate a combination that will accomplish three goals:
- Provide downside protection against a substantial loss in share value
- Provide an opportunity of limited share appreciation from current market value up to the call strike price
- Result in a low or no-cost option collar or a zero-dollar collar
Here is the options chain:
Note the following with HELE trading at $103.19:
- The out-of-the-money $105.00 call generates a bid premium of $2.55 (brown row)
- The out-of-the-money $100.00 put shows an ask price of $2.55 resulting in a zero-dollar collar
Have our three goals been met?
Provide downside protection against a substantial loss in share value
Yes. We are protected against any share depreciation below the $100.00 put strike. We are susceptible to share decline from $103.19 down to the $100.00 strike but no more than that.
Provide an opportunity of limited share appreciation from current market value up to the call strike price
Yes. We retain the potential for share appreciation from $103.19 up to the $105.00 call strike. This would represent a 1.75% 5-week return or an 18.2% annualized return.
Result in a low or no-cost option collar or a zero-dollar collar
Yes. We have an option credit on the call side of $2.55 and a put debit of $2.55 resulting in a zero-dollar collar.
Is it possible to do even better?
Yes, it is possible by leveraging the Show or Fill Rule, we may be able to end up with an options credit and still all the advantages of a collar. See pages 225 – 227 of the classic version of the Complete Encyclopedia for Covered Call Writing for details on how to accomplish this.
Disadvantages of the zero-dollar collar
As with all forms of covered call writing, the profit potential is limited by the call strike. The cost of the put premium also reduces profit potential as there is always cost to an insurance policy of this nature. Finally, we are protected against catastrophic share loss but still susceptible to some decline is share value.
For those who have a portfolio consisting of low-cost basis securities the zero-dollar collar can be a useful tool. It is a no-cost way of generating protection against significant loss in share value while at the same time still offering an opportunity for share appreciation.
New Greek Spreadsheet on Premium Site
Based on member inquiries, I created a spreadsheet showing the impact of changes in share price, volatility and time to expiration on our long and short call and put values. Look in the “resources/downloads” section of the Premium Site (right side) and scroll down to “G” You may want to print this out and leave near your computer for quick reference.
Blue Collar Scholar Competition:
Contest leaders as of Friday’s market close (S&P 500 reading at the end of the year)
Sample Commentary from Ricky S:
“People are more likely to be positive and motivated through Christmas and the New Year holiday period. Thus spending more money and enjoying the holidays”.
The six winners will be published in the January 10, 2016 newsletter.
Upcoming live appearances
1- Saturday January 23rd, 2016: Kansas City, Missouri
9 AM – 12:30 PM
Matt Ross Community Center
2- New York Stock Traders Expo
February 21st – 23rd
Marriott Marquis Hotel, NYC
Markets were extremely volatile this week, as investors reacted to the first US interest rate hike in nine years. Other economic data came in mixed, and included modest signs of recovery in China and the eurozone. The Chicago Board Options Exchange Volatility Index (VIX) remainewd around 20 for most of the week, down from its previous-week high but above the mid-teens, where it had been for much of the year.The price of crude oil continued to decline to multiyear lows due to a global supply glut. This week’s reports:
- As expected, the Fed announced the first interest rate hike in nine years, reporting confidence in the economy, while giving assurances that further rate hikes would be gradual
- The federal funds rate moved up a quarter of a percentage point to 0.25%–0.50%. The vote to raise rates was unanimous.
- The US Consumer Price Index was flat in November while core CPI –– excluding food and energy –– rose 0.2%. For the year, CPI rose 0.5% while core prices were up 2.0%
- The US House of Representatives passed a spending bill Friday morning that will fund the government through September and lift a 40-year ban on oil exports. The Senate is expected to pass the bill as well. In exchange for lifting the long-time ban on exporting crude oil, Democrats secured an agreement extending wind and solar tax credits and reauthorizing a conservation fund
- US housing starts rose 10.5% in November to a seasonally adjusted annual pace of 1.17 million units
- Building permits rose by an impressive 11% to a five-month high. It was the eighth straight month of more than 1 million units in annualized housing starts, the longest stretch since 2007
- Builder confidence dipped in December. However, the one-point drop to 61 in the National Association of Home Builders/Wells Fargo Housing Market Index still indicated a positive outlook, up from 58 a year ago and well above the neutral mark of 50
- Initial jobless claims declined by 11,000 to 271,000 for the week ending December 12th. Weekly jobless claims have remained below 300,000 for 41 consecutive weeks, the longest such run since the early 1970s
- Continuing claims fell by 7,000 to 2.24 million for the week ending December 5th
For the week, the S&P 500 dropped by 3.79% for a year to date return of (-) 2.26%%.
IBD: Uptrend under pressure
GMI: 1/6- Sell signal since market close of December 10, 2015
BCI: Cautiously bullish but remaining in a defensive posture selling at least 50% in-the-money strikes and deeper out-of-the-money puts until there is clarity regarding the market reaction to the Fed rate hike.
Wishing you the best in investing,
Alan ([email protected])