Covered-call writing is a low-risk, cash-generating strategy. We can lower the risk to an even greater extent by purchasing protective puts and by writing in-the-money (ITM) call options, explains Alan Ellman of The Blue Collar Investor.

Now, buying protective puts (called the collar strategy when used in conjunction with covered-call writing) costs money and will lower our returns. Using ITM calls will reduce risk but eliminate the opportunity to generate profits from share appreciation. All strategies have their pros and cons. In this article we will compare the two risk-reduction strategies using a real-life example with Centene Corporation (CNC).

CNC 1-Month Option Chain on 4/16/2020

CNC Option-Chain


CNC Option Chain

We will calculate the following strikes with CNC trading at $71.27:

Collar

  • OTM $72.50 call ($3.90)
  • OTM $65.00 ($2.55) and $67.50 puts ($3.20)

ITM calls

  • $65.00 ($8.50) and $67.50 ($6.80) ITM calls

Collar Calculations with the BCI Collar Calculator

CNC Collar Calculations
CNC Collar Calculations

  • Red arrows: 1-month and annualized initial time-value returns
  • Blue arrows: 1-month and annualized returns if share price moves up to OITM call strike
  • Green arrows: 1-month and annualized returns if share price moves below the OTM put strike

Selling ITM Call Calculations with the Ellman Calculator

CNC Calculations with the Multiple Tab
CNC Calculations with the Multiple Tab of the Ellman calculator

  • Initial time-value returns range from 3.4% to 4.5%
  • Downside protection of those time-value returns range from 5.3% to 8.8%
  • Breakeven prices range from $62.77 to $64.47

Discussion
Risk reduction for our covered-call trades can be accomplished in several ways. Two such approaches include buying protective puts and writing ITM call options. The former will protect against all gap-downs below the put strike, but will cost money. The latter is paid for by the option buyer in the form of intrinsic value, but will eliminate the opportunity to generate additional profit from share appreciation.

Learn more about Alan Ellman on the Blue Collar Investor Website.