By Mike Parnos of Online Trading Academy*
In the first of this 2-part series (“Covered Calls, Part 1 of 2) we discussed covered calls. There are good points and bad points to the strategy. My biggest problem with covered calls is that you're exposed for the entire value of your stock down to zero.
That's a lot of risk -- too much -- unless you know how to control it. Some people are obsessed, which is hardly breaking news. Controlling one's obsessions is easier said than done. But, they say that admitting the problem is half the battle.
People say "no" to drugs. They may say "no" to alcohol, but many can't bring themselves to say "no" to owning stock in this market -- a potentially fatal character flaw that may result in the untimely death of their portfolio. This disease is one that not even a 12-step program will help. Why? Because you'll likely be broke before you get to step 6.
If You Absolutely Must
Let's proceed to that world where the path of least resistance and the path to profits are one and the same. We're going to try to help those lost souls who have no control and simply MUST own stocks in this (or any) market environment.
In one sense, I applaud the utopian "glass is one-third full" optimistic approach to managing money. Optimism is a good quality. But, it has absolutely nothing to do with reality. Dear optimistic directional traders: Be sure to let me know what it's like to stand in line for government cheese.
Maintaining a Short Leash
Maybe I can help, but, to do so, I'll have to put you on a short leash. At the end of that leash is a "collar." In essence, what we're going to do is to put a collar on your stocks, so they won't stray too far.
For example: The market has been tanking. A few months ago, you had a vision of a bottom. You bought 1,000 shares of IBM, which is (at this writing) trading at $77.81. Is there a way to be sure of market direction? Of course not -- unless you're hearing little voices or had a recent consultation with Miss Cleo. But, that's a whole other set of issues.
The fact is that we rarely have a clue where the market is going. One thing is certain, though: We don't want to experience adverse market movement without the proper protection. That's what the "collar" is for.
The Example
With IBM at $77.81, if you had sold the IBM July $80 call (a covered call), you could have taken in approximately $.80 ($800 for 10 contracts). Now, where is this $800 going to do you the most good? It's a matter of priorities.
You could:
1) Fly to Las Vegas, catch a show, dine at the $6.95 buffet and gamble the rest away
2) Apply it to your wide-screen TV or liposuction fund
3) Treat yourself (or your spouse) to the local spa for a Botox treatment and a full day of pampering
OR, you could:
4) Purchase some insurance on your $59,000 investment.
The astute options trader will resist the temptation of choices 1 - 3. He or she will use the $800 to buy 10 of the July $75.00 puts for approximately $.70 ($700). This would, in effect, protect you if IBM moves down.
Keep in mind that IBM may be only an earnings warning or an accounting irregularity away from $65. The $75 put would protect you on any IBM transgression below $75 (all the way down to zero) through July option expiration.
Now, let's look for a way to help finance our "protection." Look at the possibility of selling an out-of-the-money call against your stock shares. The sale of a call (covered by the shares) will usually pay for all, or most of, the insurance put. Look at the chart shown subsequently. The July $80 call is selling for $.85.
In this case you'd actually have an extra $.20 ($200). The $2.81 difference between the $75 put strike price and the $77.81 price of the stock is viewed as the "deductible."
If You Don't Sell the Call
The cost of this insurance for the July cycle is roughly $.65 per share per month -- IF you don't sell the call. If you truly believe IBM is headed up, the added $.65 cost for your insurance is pretty insignificant.
The longer-term investor can lower his or her cost per month by purchasing puts further out. You could even buy an option out to January 2007 for about $2.65. That would bring your cost of insurance to approximately $.38 / month.
If you don't sell the call to finance your insurance, you're not putting a cap on your profit potential. IBM can go to the sky -- without any encumbrances. If IBM moves up significantly, you can sell the current protective put and buy another protective put at a higher level --locking in a large percentage of your profits and, once again, have the necessary protection.
The "collar" limits what could be a catastrophic loss to a tolerable deductible and allows for IBM to appreciate by $2.22 before you're at risk of losing the stock through assignment. You can repeat the process month after month until your stock gets called away -- which is a good thing! It means you made money, which, if I'm not mistaken, is the object of this exercise.
You Gotta Know When to Fold ‘Em
Some people do, however, become attached to their stocks. They carry a grudge. It's simply not healthy -- emotionally or financially. They think that, if they lose money on a particular stock, they have to make it up in the same stock.
When you buy a stock, where does it say "till death do you part?" Remember, it's only a stock. Don't become emotionally involved. If it goes, it goes. Add up your profits, smile and get on with your life. If it goes down, take your loss like a man and move on with your life.
There are no monogamy laws or divorce penalties in the stock market. You can play the field. There are thousands of other stocks out there. Just make sure you use "protection." Sound vaguely familiar?
By the same token, if you're bearish, you can construct the same scenario by shorting a stock, selling an out-of-the-money put and buying an out-of-the-money call to protect your short stock position.
In most cases, you're allowed to sell covered calls in your IRA. Most brokerage firms will allow you to establish "collar" positions by purchasing the protective put in your IRA. If your broker doesn't permit this, you have the WRONG broker.
Having Your Cake and. . .
In summation, you can have your cake and eat it too. The "collar" enables you to own a stock, have room for profit, possibly pocket a few dollars and be protected on the downside. You'll find that having your cake and eating it beats the heck out of the prospect of digesting that government cheese.
We're not going to cure the stock ownership disease with the "collar," but we can bandage the wound and stop the bleeding -- at least temporarily. However, don't be surprised if, before long, the obsessive-compulsive stock buyer is back out there, unprotected, still trying to catch those falling knives with bare hands.
Go figure.
*Reprinted (and modified) with permission from Mike Parnos of Online Trading Academy (http://www.tradingacademy.com)
