Exit strategies are critical to deploying our capital as efficiently as possible because we don't want our cash to be locked up in a trade for a very long period of time. Purchasing puts with the same expiration date will alleviate substantial losses since our maximum loss is defined, information which selling covered calls or cash-secured puts won't give us (unless the stock drops to $0, the only thing we have left is the cash premium received).
I've already addressed the topic in my previous articles, but what about unwinding short calls and short puts when we've added protective puts to these trades? Let me separate the short calls from the short puts to make the explanations cut and dried for you.
Covered Calls And Protective Puts: The Collar Strategy
Let's get right into it: here you have a hypothetical trade utilizing the following parameters.
100 shares were bought at $204.02
We sold a one-month call with a strike price of $207.5 for $5.00
Simultaneously, we purchased a put option with the same expiration date with a strike price of $197.50 for $4.37
There's an ex-dividend date prior to expiration of 77 cents
Using my calculator, the results automatically appear:
We have an initial return of 0.69% including the dividend which is about to be subtracted from the share price PRIOR to expiration. If shares are above the strike price, we've maximized our profits.
Now, what if shares move up dramatically to $225 in a very short period of time? When this occurs, we know the calls have at least $17.50 of intrinsic value.
Let's have a look at the following parameters that make the whole concept of closing out early come alive. Having the introductory information in the background, the call option rose sharply to $17.8, while the put premium amounted to just $0.30. We've had the ex-dividend date earlier in the contract cycle, so we do collect the dividend of 77 cents.
If we close out our trade, we have a realized return of 2.39% before commissions if we sell the put option and collect $30 on that sale. This is $488 divided by our cost basis of 100 shares worth $20,402. The cost-to-close is 0.15%, that's the lost return we have to make up for if we want this exit strategy to bear fruit.
Bull Put Spread
We can do the same with cash-secured puts and protective puts, also known as the put bull spread since we benefit from a stable or rising share price.
We sold an out-of-the-money put with a strike price of €200, indicating we have downside risk protection of our time value profit.
We spent €3.70 on purchasing the €195 put.
The initial return is 0.65% while our potential maximum loss is defined at 3.86%.
When the share price shot up to €225, we now have the following situation:
We bought back our short put for 30 cents and got 10 cents on the sale of the €195 put. This leads to a realized return of 0.55% and a lost profit of 0.15% (if you were to hold this position to expiration, we would almost fully capture the entire targeted profits).