Q & A. Stretched Collar (LEAPS Puts and Short-Term Calls)


Mark,
I'm buying your book based on that excellent answer! [For readers who want to know which answer, it's this post.] While I wait (impatiently) for it to arrive may I ask; if selling OTM covered calls and collecting dividends is my (income) strategy then would I be wise (after IV calms down a bit) to buy insurance puts w-a-y out, say a year or so? They seem relatively inexpensive and the (then fixed) cost could "amortized" over the next 12 months as I roll through various call contracts… (Commissions would be less too). Yes, I wish I'd done just that a year ago, but is this a strategy to consider going forward?

Thanks, Dave


Dave, Thank you.

For readers who want know to which answer Dave is referring, it's the first comment to this post.

Yes, it's a strategy to consider.  But it's not quite as advantageous as it appears to be.  You will have to play with the numbers, using an option calculator, and decide if it works for the specific stocks you own.

I know some of the statements below are obvious to you,  but am including these details for the benefit of other readers.

In today's low-commission world, commissions should not be a factor in your trading decisions.  If it is, you may be using the wrong broker for your trading style.

1) You obviously prefer to take a bullish stance on the market, and want to make good profits on a substantial rally. At the same time you are looking for a reasonably priced insurance policy.

2) By waiting until things 'calm down' you are taking the chance that there will not be another substantial meltdown before you buy those puts, but in return, you avoid paying today's high option prices.

3) Yes, long-term puts (LEAPS) are 'cheaper' when you look at the time decay per day.  But,these are vega rich options – meaning that if IV drops, the price of these puts will decrease dramatically.  If you buy these puts – just for the insurance aspect – then you should not care if the price declines, because they still afford the same protection.  But…

4)There is one serious problem that investors forget to consider when buying longer-term options for protection.  And that's price of the underlying. If your stock is in the $50 to $60 range and you decide to buy a LEAPS put with a strike of 45 or 50 – you get good protection, even though the put is costly.  But what happens when the stock rallies?  If it moves to 70, then you have little protection.  And besides that, you may be forced to buy back your call at a loss (or lose the stock via assignment).  If you no longer own the stock, you will have a nice profit on the covered call part of the position, but there's going to be a substantial loss when selling the put.  You don't want to adopt this method unless there's a decent profit on the overall position.

If you don't lose the stock, you can buy a new put with a more appropriate strike price and sell the put you own.  That allows you to maintain sufficient protection.  But, it costs additional premium.  The difficult part is trying to decide just how much you can afford to pay for insurance – especially when profits are limited by your sale of call options.  And you must sell calls, because that's a vital part of your strategy.

There's no free lunch here.  You must give up something to gain something.

I'm NOT saying this is a bad idea.  But I am warning you that you may spend so much on insurance that you cannot earn a profit.  If you are dealing with a dividend paying stock, then the OTM calls you write will probably provide minimal income, so consider the cost of doing business this way.  The long-term puts may be inexpensive enough to make this viable.  Just check the numbers carefully before deciding.   You probably don't want pay $6 for puts and sell front-month calls for $0.40.

Sometimes it's better to own puts with shorter lifetimes, even though the daily time decay is greater.

Mark

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