Updated: Aug 6, 2019
As a conservative investor I feel very comfortable with my arsenal of exit strategies to enhance my option profits to even higher levels, and even more comfortable than the ordinary shareholder when the markets drop precipitously. Nonetheless, despite the fact that selling OTM puts or ITM calls creates downside risk protection of your profits, there's no guarantee of fully earning your premium when markets selling off dramatically. In other words, is there a way we can cap our losses completely in case of a melt-down? There definitely is such a strategy known as the collar strategy. In return for being offered LIMITED downside risk by buying the put option (it gives us the RIGHT to sell shares at the strike price), there's a tradeoff: a lower return will be generated.
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. This strategy should be heavily considered by investors who feel there might be some upcoming weakness in the share price of an underlying security that was purchased at significantly lower prices than current market value. So, in order to mitigate potentially huge losses on share value, some of you out there may want to add protective puts to their portfolio and lower the COST OF THIS INSURANCE by selling covered calls against long positions.
Let's take off our shoes and socks and dig deeper into the mathematics behind such a strategy utilizing Apple as the underlying security that we're selling calls on. As of August 2, 2019 shares of Apple were trading at $204.02 and the options chain contained the following information. The prices circled in red represent the premiums received from selling the calls and paid for the puts. I'm using the contracts expiring on September 6, 2019. Mind the upcoming ex-dividend date that results in a dividend of 77 cents per share.
Selling the $207.5 calls will generate an initial return of 2.45% with the opportunity to earn an additional 1.70% not to mention the dividend of 77 cents. Factoring in that future dividend payment, our maximum return would be 4.53%. Our breakeven including the dividend is $198.25. Now, we can opt for real protection of our position by buying the $197.5 put but that will result in a net debit in our account.
Let's feed that information into the calculator to see how things play out.
Adding the put to our trade, our initial return will be a lot lower namely 0.69% (an annualized return of 8.4% doesn't sound that brilliant), but we have an opportunity to generate up to 2.39% (annualized return of 28.8%) if Apple is at or above the strike price by expiration. Our maximum loss amounts to 2.51% so we've capped the downside no matter how low Apple shares could drop in value. Our breakeven level is higher compared to a traditional covered call trade because of buying the put which costs us cash. Nevertheless, should markets sell off dramatically, we are safe because of limited downside risk. In other words, we don't have to care about potentially rolling down our strikes or completely exiting our trades. We know what we'll earn for every single share price
If things turn out much better than we anticipated, we can lean toward exit strategies to free up our funds and reinvest our capital in new option selling trades in the same month. It's a great thing if you can do it and it's not rare!