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Covered-Calls 101

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A Different Covered-Call Strategy

With the current uncertain market outlook, investors are focusing on ways to reduce capital draw-downs in their stock portfolios. One alternative involves buying stock and subsequently selling "covered" calls, thus lowering the cost basis in the issue while limiting upside potential. Another popular approach entails purchasing both stock and put options, thereby maintaining upside potential with little or no downside risk until the options expire. Both methods are commonly used as insurance against short-term declines in the market but they each have disadvantages. However, when these techniques are combined, the resultant position is often more effective than either of its individual components and the strategy is known as a "collar."

The (bullish) collar is a technique which provides downside protection for stock ownership through the purchase of put options that are financed with the sale of call options. In short, an investor sacrifices upside potential for downside protection with fixed limits established for both risk and reward. The name of the strategy stems from the "collared" profit-loss outlook, which is determined by the cost of the underlying asset and the respective strike prices of the long and short options, as well as the net debit (or credit) for the option portion of the position. By purchasing (cheap) put options and selling (inflated) call options, a collar often can be established for little or no out-of-pocket expense.

Here is a hypothetical collar position using current price data on a relatively bullish issue in the energy sector. The name of the stock has been omitted to eliminate the possibility of this example being construed as a recommendation.

XYZ STOCK PRICE = $35.05

SELL SEP-40.00 CALL BID = $2.05 per contract ($205 total)
BUY SEP-30.00 PUT ASK = $2.10 per contract ($210 total)

COST BASIS (LESS COMM.) = $35.10 per share
MAXIMUM UPSIDE PROFIT = $4.90 per share ($490 total)
MAXIMUM DOWNSIDE LOSS = $5.10 per share ($510 total)

An investor purchasing 100 shares in this position would have to pay $3,505 (or $1,752, if stock was bought on margin). The price of the option portion of the transaction is a net debit of $5.00, due to the additional cost (above the credit received for the call) for the put option. Obviously, commissions can have a significant affect on the potential profit or loss in a combination position, so the exact prices should always be calculated prior to initiating any trade. With regard to the possible outcomes, a number of things can happen to the stock between now and the September options expiration:

1) The stock could remain between $30 and $40, which means both the call and the put would expire worthless and you would own 100 shares of XYZ at the current value, with no impact on the position from the options.

2) The stock could fall below $30 prior to the expiration of the put option and in that case, the maximum loss would be $500, regardless of how much the share value declined. This is the advantage of the "insurance" portion of the collar because in a stock-only position, the losses would continue to increase as the price of the issue fell further.

3) The stock could continue to rally in the coming months, moving to $40 and beyond. If this occurred, the investor could adjust the position upwards (repurchasing the call and selling a higher strike option) or the options could simply held until assigned at $40, which would yield a gain of $490 on $3,510 invested over a period of 6 months (28% annualized profit).

As you can see, the advantage of a collar when compared to simply purchasing a protective put is the substantially reduced out-of-pocket cost. Recall that the proceeds received from the sale of the covered-call is used to pay for the put. The shortcoming of a collar is the upside limit it places on the stock's profit potential. The sold (short) call establishes a maximum amount of profit that can be earned from an increase in the stock's price. For conservative investors, the put options act as a safety net in the portfolio, protecting its value against catastrophic declines in a specific issue. The sale of call options generates income to offset the cost of the protective puts while, at the same time, sacrificing a portion of potential gains.

With regard to option pricing, the strategy is best used when call premiums are higher than the equivalent put premiums. This type of disparity is often referred to as a volatility skew and it tends to occur in active stocks with upcoming events or announcements that have the potential to significantly affect share value. Earnings reports, FDA reviews, and merger/acquisition-related activities are among the most common reasons for inflated options prices and traders can exploit many of these opportunities by purchasing discounted puts and selling inflated calls on portfolio positions.

Depending on the quality of the stock and its near-term outlook, the collar can be a very attractive technique for conservative investors who want to establish a favorable risk versus reward ratio in potentially volatile market environments.

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