Since You Asked
Got a question about options? Tom Gentile is the chief options strategist at Optionetics (www.optionetics.com), an education and publishing firm dedicated to teaching investors how to minimize their risk while maximizing profits using options. To submit a question, post it on the STOCKS & COMMODITIES website Message-Boards at http://Message-Boards.Traders.com. Answers will be posted there, and selected questions will appear in future issues of S&C.
Tom Gentile of Optionetics
COVERED CALLS FOR PROTECTION
I am concerned about the markets going forward and want to know if there is any way of protecting my stock portfolio using options instead of liquidating my position. I have heard of covered calls -- do they work as a good protection strategy?
Yes, you can protect your portfolio of stocks by using options. The first way a trader can help protect a stock from falling hard is to sell option premium against the shares. This is known as covering your stock position, or a covered call. In a covered call trade, you are buying the underlying stock shares and selling call options against them. This strategy is best implemented in a bullish to neutral market, where a slow rise is anticipated in the market price of the underlying stock. This technique allows traders to handle moderate price declines, because the call premium reduces the position's breakeven.
Since you are counting on the time decay of the short option to render the short call worthless, you do not want to sell a call more than 45 days out. However, since the profit on a covered call is limited to the premium received, the premium needs to be high enough to balance out the trade's risk. Covered calls are the most popular options strategy used in today's markets. If a trader wants to gain additional income on the same stock, he or she can sell a slightly out-of-the-money call every month. The risk lies in the strategy's limited ability to protect the underlying stock from major moves down and the potential loss of future profits on the stock above the strike price.
I have heard that buying puts can help you protect your stock positions as well. What would I look for in put protection?
This is another way to protect your stock positions: buying puts. We all have insurance on our homes, cars, and ourselves, but most people don't know you can buy insurance on your stocks. In the long-put strategy, you are purchasing the right, but not the obligation, to sell the underlying stock at a specific price until the expiration date. This strategy is used when you anticipate a fall in the price of the underlying stock. A long-put strategy offers substantial profit potential with limited downside risk. It is often used to get high leverage on an underlying security that you expect to decrease in price, but can be equally effective in protecting stocks.
The only problem is this insurance can be costly, depending on the stock. One alternative is to spread your puts in a vertical spread, using lower-strike puts to offset the cost of the higher-strike put used for protection. This can greatly reduce the total cost, but also limits the downside protection.
I have heard you can completely protect your stock portfolio with something called a "collar." What is a collar and how does it work?
A collar is the combination of the long put and the short call. This strategy offers a cost-free hedge involving buying at-the-money puts and selling at-the-money calls at the same time to protect long stock positions. Basically, for every 100 shares of stock you own, you could protect them by buying one at-the-money put and selling one at-the-money call for a net cost of zero, provided the puts bought and the calls sold are trading at the same price.
The great thing about this strategy is that it offers complete downside protection and allows for continued profit up to the strike price of the call sold. The premium received on the call equals the money paid to buy the put. The only negative: If the stock continues to rise above the call strike price, the call may be assigned, limiting the profit on the long stock position. And what if you are right and the stock continues to fall? The put would increase in value, and the call would diminish in value.
Once I implement a protection strategy for my stocks, how do I exit when the time comes to get out?
Exiting these strategies is not as hard as you might think. For the covered call strategy, simply let the call expire worthless. If the price of the stock were to rise above the call, simply buy the call back, and sell another month if you would like to continue to hold premium.
You have three options when you want to exit the long-put position. You can sell the put option for its current value, or you can let the option expire. If the stock drops hard and the put is deep in-the-money, consider exercising the put and buying the stock at the current level. This should eliminate any slippage that selling the deep in-the-money put would incur.
Finally, to exit the collar spread, as long as the stock is above or below the strike prices, the stock will automatically exercise or get called away. If the stock is at the money near the expiration date, the best thing to do is unwind the position to avoid confusion of whether exercise or assignment will occur.
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Originally published in the August 2002 issue of Technical Analysis of STOCKS & COMMODITIES magazine. All rights reserved. © Copyright 2002, Technical Analysis, Inc.