Covered call exit strategies play a major role in mitigating losses in our BCI methodology. In most cases, we can keep losses to a minimum, turn losses into gains and enhance profits as well. Some covered call writers want the security of protecting against a catastrophic gap-down which can occur rarely. With the current market volatility caused by the coronavirus crisis, I felt this would be an appropriate topic to discuss. One way to accomplish this is by purchasing a in what is known as the strategy. Here’s how it works:

The collar strategy

  • Buy a stock
  • Sell an out-of-the-money call option (strike higher than current market value)
  • Buy an out-of-the-money put option (strike lower than current market value)

Goals of this strategy

  • Generate cash flow
  • Protect against catastrophic price decline in the underlying security (advantage)

Disadvantages

  • Lower returns
  • Managing 3 positions instead of 2

Real-life example with Commercial Metals Company (NYSE: CMC)

In this article we will calculate the hypothetical returns using no puts (initial calculations using The Ellman Calculator) in one case and evaluating 3 different strike prices for implementing the collar strategy with protective puts (using the BCI Collar Calculator). I am using Commercial metals Company in this example as it has been appearing on our premium watch list in December 2019, has decent returns and several choices of strike prices. Here are the stats at the time I am writing this article:

CMC Stats on 12/31/2019

Current price = $22.33

Call strike selected = $23.00

Put strikes to evaluate = $18.00, $19.00and $20.00

CMC call option-chain

CMC Call Option-Chain on 12/31/19

 

CMC Initial Calculations using as of 12/31/19

CMC: Initial Time-Value Return Calculations

We glean the following stats from the

4.0%, 7-week return

3.0% upside potential from current market value to the $23.00 strike

7% potential 7-week return

52% maximum potential annualized return

 

CMC put option-chain

CMC Put Option-Chain on 12/31/19

CMC Collar Calculations using The BCI Collar Calculator as of 12/31/19

CMC Collar Calculations on 12/31/19

Initial returns range from 1.79% to 3.13% or 12.57% to 22.00% annualized. If share price moves above the $23.00 call strike, maximum initial returns run from 4.79% to 6.14%. If share price declines below the put strike, losses range from 8.64% to 16.26%.

Discussion

  • The initial return not using protective puts is significantly higher than when including them (ROO column)
  • If the share price closes above the call strike price (>call strike column), not buying a put produces the best results (7%)
  • If the share price closes below the put strike, the smallest losses occur for the higher strike put prices but all still result in losses
  • Position management can also be used in the collar strategy but is more involved and may require more time because the investor is in 3, rather than 2, positions

Commentary

Using protective puts or the collar strategy for covered call writers is a viable and sensible approach to this strategy. However, it does have its advantages and disadvantages. The main advantage is that the call writer is protected against catastrophic share depreciation below the put strike. This is especially beneficial in volatile markets like we are experiencing now. The main disadvantage is that the initial profits generated from the sale of the call option will be substantially lower due to the debit resulting from the purchase of the put. The main reason for a stock price gap-down is a disappointing earnings report and we avoid those situations in our BCI methodology. However, unexpected bad news can come out at any time. Although that scenario is rare, some investors may prefer the protection afforded by protective puts. There is no right or wrong here. Each investor must make his (her) own determinations. I personally do not buy puts but have absolutely no problem with members who do. In extreme markets as we are currently experiencing moving to cash and using inverse ETFs can also play useful roles.

 

For more information on the collar strategy

Book

Collar Calculator

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:

Alan,

Great video and great strategy. Thank you for posting and providing your educational perspective on this. I appreciate everything you do to help the retail investor truly be the CEO of his/her own money.

 

Many thanks,

Joe

 

Upcoming event

1. Wednesday April 8, 2020 Options Industry Council (OIC) Free Webinar

4:30 ET

Covered Call Writing to Generate Monthly Cash-Flow:

Option Basics and Practical Application

Register here.

2. East Michigan AAII Chapter: Live Webinar

April 23 @ 7:00 pm9:00 pm

Covered Call Writing to Generate Monthly Cash-Flow

Option Basics and Practical Application

Thursday April 23rd

7 PM – 9 PM

Login information to be sent to registered members.

Alan speaking at a Money Show event

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Market tone data is now located on page 1 of our premium member stock reports and page 8 of our mid-week ETF reports.

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