Buying Insurance for Your Trades

04/16/2010 12:01 am EST

Focus: OPTIONS

As you might recall, a covered call has capped upside potential, while the downside risk is only protected until the stock goes below the purchase price minus the amount of the premium received from the sold call. For instance, selling of an OTM (out-of-the-money) call would give us "skinny" premium, and if the stock drops more than the amount of proceeds obtained by selling that OTM call, then what? Our protection from downside risk was equal only to the amount of premium received. Had we sold an ATM (at-the-money) call, we would have received "juicier" premium and greater protection to the downside, yet selling an ATM call would also represent a greater possibility of having our long stock called away. Every time we sell a call option contract, we take upon ourselves the obligation to sell our long stock. So how can our OTM covered call allow us to have greater potential to hold onto our long stock for greater participation on a move upside than if we had sold an ATM call, while still being protected from not just some, but the majority of the downside risk?

Well, there is an option strategy specifically designated for this, and it's called a “collar.” When a trader does not want to sell the stock he or she owns, then a collar strategy could be applied. Let me briefly explain the mechanics of the strategy by using XLF as an example. For instance, XLF has been channeling between the $16.00 and $13.00 range. Just recently, it had broken out of that range, and at the time of writing this article, it was trading around $16.40 plus or minus. Hence, if we already own a hundred shares of XLF at $16.00, then we could sell a single contract of the 17 OTM call, giving the XLF room to move to the upside $1.00. Then the proceeds received from the sale could be applied to the purchase of an OTM put.

The bought put is going to act as protection from the downside. For those unfamiliar with the protective put strategy, I suggest reading up on what we call “married puts.” Below is the option chain of XLF with a red oval circling the premium of the sold 17 call and bought 15 put.


Click to Enlarge

Observe that the 17 call was sold for $0.21, while the 15 put was bought for only $0.13. In other words, the sold OTM call has paid for the bought OTM put, even leaving us some change to keep ($0.08). Just think about the perfection of this strategy. We can hold on to this long asset position while we have downside protection if the XLF drops below $15.00, yet at the same time, we are giving XLF room to go up to the $17.00 price level.

Next, let us go through three possible scenarios: The XLF going sideways, up, or down. For simplicity's sake, I will go over each one separately.

Scenario 1: XLF Stays Within the Range Between 15 and 17

In such case, our sold 17 call expires worthless as well as our long put. A stagnant XLF might appear as an undesirable outcome, yet keep in mind that when we sell something, we do want it to expire worthless. The 17 call expiring worthless is not what we should focus on. Our focus would normally have been on the 15 put, which has lost value. But because of the sold call, we had the benefit of the insurance without any additional expense to us.

Scenario 2: XLF Rallies Higher

In this case, the sold 17 call might bite us, meaning our shares could get taken away from us unless we buy back the sold call for a higher price than what we initially sold it. Even if we do that, this scenario should not be seen as a bad deal, because after all, our long asset has made us money. Meanwhile, the long put would have lost its value. By the way, the put may not necessarily lose all of its value, and if it became clear to us that the price wasn't going down, we could close or remove the collar by simply selling the put back to the market makers at whatever small value that was still left in it.

Scenario 3: XLF Falls Below 15

If XLF tanks, our losses will occur from $16.00 minus the credit received ($16.00-$0.08=$15.92) until the stock hits the strike price of the put at 15 for a maximum loss of $0.92. Below 15, the put increases in value and insures our XLF penny for penny all the way down as far as it goes. We could either exercise our put, which in turn would "put" the hundred shares of the XLF for $15.00 a share into the account of the one who had sold us that 15 put contract. Or we could simply close out the put for profit and use it to offset our losses. No matter which way we select, we did get the best out of the worst.

When trading options, there are always choices within choices to be made. Keep thinking outside of the box. Good trading, and until the next time, watch your position sizing.

By Josip Causic of OnlineTradingAcademy.com

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