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Adding a Put to a Covered Call

When you buy a put for a covered call trade, you then have both a sold call and bought put on the stock you own.  This is called a “collar” as you have a
protective put on a covered call.  The classic collar has an at-the-money (ATM) call and put at the same strike price.  In the case of the covered call trader, the
bought put serves as additional downsize protection against a stock price decline.

When you add a put to a covered call trade, you are adding additional cost to the trade.  This will increase your cost basis for the trade. However, you can create a totally riskless covered call trade.  Let’s look at an example using Tiffany (TIF).

TIF is trading at $74.77 in the market.  You can sell the 75 Call for $4.20 and buy the 75 Put for $4.00.  If the stock is above 75 at closing, if will be called away and you gain $0.43 in profits (75-74.77+.20).  Additionally, we could sell the put if there is any value left before expiration.  In this scenario, you make money from the covered call side.

If TIF is trading below 75 at expiration, the call will expire worthless but the put will have value.  You would exercise the 75 put which will give you $75.00 for the stock shares trading below the 75 strike price.  You would then make a profit of $0.43 on the protective put side of the trade.

Tiffany (TIF) Stock
Stock Price         74.77
Sell 75 Call           4.20
Buy 75 Put           4.00
Net Premium           0.20
Net Cost         74.57
Downside Risk                –
Max Profit           0.43

 

This trade is a risk-free trade because the total cost basis ($74.57) is below both strike prices of 75.  Regardless of what happens to the stock price, you will receive $75.00 for your stock. You can say that this collar trade is an arbitrage trade because there was a positive difference between the call and put prices at the 75 strike price.  The return of $0.43 is only a 0.58% return.  When you add trading commissions to the cost basis, this can’t be arbitraged by a retail investor.  For more active traders, you can vary your timing of closing the call and put sides to increase your profit.  For example, when the sold call loses the majority of value, you can close this side by buying to close the call.  Then, you will own the stock with the put guarentee at the strike price.  There are numerous possibilities when you actively managed the collar trade if you make adjustments before expiration.

You can construct a similar trade with different strike prices for the call and put.  When you vary the strike prices this, you are changing the cost basis and risk exposure.  For example with the 75 covered call on TIF, we might buy the 72.5 put for $3.15 (see table below).  This will give us a max profit of $1.05 and
downsize risk of $1.22.

Tiffany (TIF) Stock
Stock Price         74.77
Sell 75 Call           4.20
Buy 72.5 Put           3.15
Net Premium           1.05
Net Cost         73.72
Downside Risk           1.22
Max Profit           1.05

 

The great part about this type of trade is that you are limiting the amount of downsize by using the blanket put.  If the stock market bottom falls out with a
10% correction, you will only lose $1.22 per covered call or 1.65%.

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