Tag Archives | Covered calls collars being satisfied with good profits earning more coin

Do you feel compelled to earn more than the maximum?

One of the tenets of my investing philosophy is that it's a good idea to be satisfied when the maximum possible profit – for a given trade – is achieved. 

All the option strategies I recommend come with limited profit potential.  To me, that's the cost associated with reducing, or severely limiting potential loss.  I like that trade-off.

Not everyone feels that way.  Some want to exceed the maximum possible result, and search for ways to adjust the original trade to allow for additional profits.  The risk of taking that action is always ignored.

I've corresponded with a collar owner and a covered call writer who are looking for advice on how (and when) to change their positions so they can earn 'more coin.'

Here's an example:

Covered call:

Buy  500 shares of PIG @ $46

Sell  5 PIG Dec 50 calls @ $1.50

Maximum profit $550, if assigned an exercise notice ($400 profit on stock, plus option premium)

Collar:

Same example, but add:

Buy 5 PIG Dec 45 puts @ $2.50

Now the maximum profit is reduced by the cost of the put and is only $150

When the stock, aptly named for these traders, moves beyond 50 (the strike price of the call they sold), they become obsessed over earning more money on the trade.

The answer is not difficult.  The method is to repurchase the Dec 50 call and find another, suitable call to sell.  That new call has a higher strike price.  There's more involved, but the point of this discussion is not how to solve that problem. 

The fact that neither trader was pleased when the stock ran through the strike price and each was interested in foregoing the profit already earned in an effort to earn even more.

I am not against the idea of letting profits run, if that's your style.  Nor am I against the idea of trying to earn an extraordinary gain from a trade.  But, when you adopt a strategy with a limited profit, and you earn that profit, I believe the investor should be satisfied.

Not everyone has to agree, but that's the philosophy that works for me.

So, the question is:  Is there a solution to this dilemma?  Is there a way to encourage traders to recognize that they made a good trade, have an outstanding result, and ought to walk away a happy winner, and not an unsatisfied winner?

If you have a good reason for seeking extra rewards from a position, there is nothing wrong with that.  This post is for individuals who cannot resist temptation.   It's not that they truly believe the stock is going higher or that they want to get more bullish.  The suggestion made below is intended for those who lack the discipline to accept their good fortune.  They feel compelled to seek the possibility of selling their stock at the top possible price.

I believe there is a simple solution that eliminates the need to take the risk of seeking extra profits.  There is just something about being short a call option that has moved into the money that convinces the trader he/she made a mistake, and shouldn't have sold the call.

The simple alternative.  Trade the equivalent position.

Instead of the covered call, sell the equivalent cash-secured naked put.

Instead of the collar, sell the equivalent put spread.

Example:

Naked put replaces the covered call:

Sell 5 PIG Dec 50 puts

Put spread replaces the collar:

Sell 5 PIG Dec 50 puts

Buy 5 PIG Dec 45 puts

Let's look at this from the point of view of the trader.  When the stock rallies, the position continues to earn more money as the Dec 50 put shrinks in price.  There is no compelling urge to buy that put and replace it with another put at a higher strike price.

As the stock continues to rise, the investor smiles as the put premium erodes. 

The profit potential is the same with the original spread or it's synthetic equivalent.

When short the call that is continuing to increase in value, the trader can become upset.  When short the put that continues to move farther out of the money, the trader is satisfied.

It's the equivalent position.  It's the same profit.  It just looks and feels different to the trader who does not recognize that it's okay to be short an ITM call when it's covered.  Choosing the equivalent trade just makes it psychologically easier for some traders.

If you are one of these traders, do yourself a favor and adopt the simpler put strategy instead of the covered call or collar.

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