One of the most important components to investing success is to protect your capital. One big loss such as a stunning 50% in a single position will require a 100% gain to get your capital back to EVEN! However, if you limit your risk to 5% or less in a single position then you can easily get your capital back to even on the next trade. So how do you limit your risk exposure when trading covered calls?
The Blanket Put strategy allows the generation of real profits while limiting the amount of risk to just a few percentage points of the trade debit. The Blanket Put is simply buying the stock, selling a call and then buying a long-term put. This strategy is great for markets with high volatility and when there is uncertainty of future market direction. The major focus here is to buy a CHEAP put so that you do not spend much of your premium on protection. The Blanket Put is to ensure you get the Return of Your Capital. We want to do this at the cheapest price possible as we are buying the Blanket Put.
Let’s walk through an example with Intel (INTC). The table below shows the monthly results for the covered call with Blanket Put. We buy 100 shares of Intel at $21.50 per share. We then sell the next month 21 call at $1.25 for a net debit of 20.25 on the covered call. To setup the Blanket Put, we buy the April 21 2012 put for $2.20. This brings our total net debit to $22.45. The Blanket Put has a strike price of 21 so we are guaranteed to be able to sale our INTC shares at this price between now and April 2012 expiration day.
We want to sell a 21 call for the next month until April 2012 expiration. We have used 1.00 for the call premium each month but this can be higher or lower in the live trade. After the Dec 2011 expiration we have a net debit of $20.45 for a guaranteed profitable trade. In total, we will collect $7.25 in total premiums for a total return of 44% in only 7 months or 75% annualized. This calculation excludes the dividends and trading commissions.
To manage the trade when you get called out on the covered call, you have two options: (1) buy back the stock and keep the put in place or (2) sell the put and start a new trade at the current stock price. You need to keep in mind that INTC is a dividend payer so you get this payment each quarter. Also, INTC is known for increasing their dividend so this stock is great for holding long-term in your portfolio.
