Selling covered calls against a long stock or ETF position is a great way to hedge risk and smooth volatility. Selling a covered call on the S&P 500 on a monthly basis has been shown to not only reduce volatility but to increase returns over the long term. However, considering current market conditions many investors are looking for even more downside protection against market downturns.
Trading a covered call / protective put combination can be a great way to harvest many of the benefits of a covered call while maintaining fixed risk to the downside. This strategy combines two of the most common uses for options, both of which are focused on protecting against losses while still providing an opportunity for profits.
[VIDEO] How to Use Option Collars to Protect Your Stock
The strategy is relatively simple. In the video I will walk through a case study using the Russell 2000 ETF (IWM) by selling an at the money call against a long position in IWM (the covered call) and buying an out of the money put (the protective put) to limit losses. The short call will provide a premium for potential profits and the protective put limits the risk in the position.
Assume that you were interested in dipping back into the market following the March 2009 rally. IWM looks like an interesting opportunity but is at a potential resistance level and stepping in at this point with an outright long position may be too risky. To improve the risk profile of this position you could sell an at the money covered call and then buy an out of the money put – both with April expirations.
In the video the prices I used were as follows.
April 41 call: $2.22 Premium received
April 39 put: $1.10 Price paid
The long put has reduced the premium received from the call to $1.12 per share or $112 per contract. The offsetting benefit of this reduction is that there is now a maximum loss of $1.27 a share no matter how far the stock drops. For this case study imagine three potential outcomes at expiration in April.
1. The stock rises to $43 per share.
The stock will be “called out” at $41 creating a $.37 loss offset by the $1.12 per share net option premium for a gain of $.73 per share or 2%. This is the maximum gain that month.
2. The stock stays flat at $41.39 per share.
The stock will still be called out at $41 creating a $.37 loss offset by the $1.12 per share net option premium for a gain of $.73 per share or 2%. This is the maximum gain for April and the results look identical to scenario #1.
3. The stock falls to $35 per share.
The stock falls to $35 creating a loss of $6.39 per share which is offset by the put (which is now worth $4.00) and the net option premium of $1.12 per share. This has limited the actual loss to $1.27, which is the maximum possible loss that month. The benefit of this strategy is that losses won’t exceed the maximum of $1.27 if the market moves against your forecast.
Keep in mind that in any of the three potential outcomes you can reenter the trade the next month and every month after that should you choose to do so. As market events unfold you may choose to loosen the risk control to allow for more upside potential. This kind of strategy is extremely flexible and allows you to adjust it for your own risk tolerance.