Weve devoted a chunk of time discussing covered calls. There are good points and bad points to the strategy. My biggest problem with covered calls is that youre exposed for the entire value of your stock down to zero. Thats a lot of risk too much unless you know how to control it.
Some people are obsessed, which is hardly breaking news. Controlling ones obsessions is easier said than done. But they say that, if you can admit the problem, its half the battle.
People say no to drugs. They may say no to alcohol. They may even say no to Jessica Alba (I cant imagine why), but many cant bring themselves to say no to owning stock in this market a potentially fatal character flaw that may result in the untimely death of your portfolio. Its a disease that not even a 12-step program will help. Why? Because youll likely be broke before you get to step 6.
If You Absolutely Must
In one sense, I applaud the utopian glass is one-third full optimistic approach to managing money. Optimism is a good quality. But it has absolutely nothing to do with reality. Dear optimistic directional traders: Be sure to let me know what it's like to stand in line for government cheese.
Maintaining A Short Leash
For example: The market has been tanking. A few months ago you had a vision of a bottom and it wasnt your wifes. You bought 1000 shares of IBM which is (at this writing) trading at $77.81. Is there a way to be sure of market direction? Of course not -- unless youre hearing little voices or had a recent consultation with Miss Cleo. But thats a whole other set of issues.
The fact is, we rarely have a clue where the market is going. One thing is certain. We don't want to experience adverse market movement without the proper protection. That's what the "collar" is for.
The astute options trader will resist the temptation of choices 1-3. He will use the $800 to buy 10 of the July $75.00 puts for about $.70 ($700). This would have, in effect, protect you if IBM moves down. Keep in mind that IBM may be only an earnings warning or an accounting irregularity away from $65. The $75 put would have protected you on any IBM transgression below $75 (all the way down to zero) through July option expiration.
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Now, lets look for a way to help finance our protection. Look at the possibility of selling an out of the money call against your stock shares. The sale of a call (covered by the shares) will usually pay for all, or most of, the insurance put. Look at the chart below. The July $80 call is selling for $.85. In this case youd actually have an extra $.20 ($200). The $2.81 difference between the $75 put strike price and the $77.81 price of the stock is viewed as the deductible.
If You Dont Sell The Call
The collar limits what could be a catastrophic loss to a tolerable deductible and allows for IBM to appreciate by $2.22 before you're at risk of losing the stock through assignment. You can repeat the process month after month until your stock gets called away which is a good thing! It means you made money, which, if Im not mistaken, is the object of this exercise.
You Gotta Know When To Fold Em
There are no monogamy laws or divorce penalties in the stock market. You can play the field. There are thousands of other stocks out there. Just make sure you use protection. Sound vaguely familiar?
By the same token, if youre bearish, you can construct the same scenario by shorting a stock, selling an out-of-the-money put and buying an out-of-the-money call to protect your short stock position.
In most cases, youre allowed to sell covered calls in your IRA. Most brokerage firms will allow you to establish collar positions by purchasing the protective put in your IRA. If your broker doesnt permit this, you have the WRONG broker.
Having Your Cake And . . .
Were not going to cure the stock ownership disease with the collar, but we can bandage the wound and stop the bleeding at least temporarily. However, dont be surprised if, before long, the obsessive-compulsive stock-buyer is back out there, unprotected, still trying to catch those falling knives with bare hands.
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Who Is This Guy? --
For serious traders, Mike offers a comprehensive two-day seminar covering many fascinating and profitable non-directional strategies. Feel free to send questions and/or comments to Contact Support Parnos1@comcast.net.
Over the years, he has learned from his mistakes, and the mistakes of others,
and he's here to share his wisdom with you. "Trading is as much psychological as
it is skill," says Mike. "Keep an open mind. You never know what might find its
way in there."