Stocks - CC – PP (Stocks - Covered Call – Protective Put) Strategy
We all know that trading stocks involves stress and risk. At the same time it can also be highly profitable. Trading can give the most return on investments as compared to other investment strategies including real estate. For example, savings, money market accounts or CDs may give a return of 2 to 5% at best. You may expect a 10% rate through mutual funds. However, under the current economic conditions, such a yield may be hard to come by even with a long term investment. Also, you do not have control over your investments and you can not be sure if your financial consultant either. What then is a low risk and more profitable alternative?
The purpose of this article is to illustrate one such low risk, high profit trading strategy, which combines stocks and options.
Covered calls and protective puts are enabled in most of the trading accounts by major brokers. (Ameritrade, Scottrade, E-trade, etc)
Covered call is – you buy stocks and sell 1 call (contract) for every 100 stocks you buy/own.
Protective put is – buy 1 put for every 100 stocks you own. In this strategy we buy a put which expires at least 6 months later.
When the stock price goes up, call price goes up and put price goes down. Elapsed time will have negative impact on put price.
Here’s the Stocks - Covered Call – Protective Put Strategy
Look for an up-trending, optionable stock. For this example, let’s call it XYZ. Let’s assume XYZ stock is currently trading at $69 per share. Assume that currently we are in the first, second or third week of February. You buy 100 stocks of XYZ.
Next, you write a covered call on XYZ, at a strike price of 75, for March. This gives you an additional income, but you have an obligation of selling the stock, at $75. Say you get $150 from writing the covered call.
However, just because the stock is an up-trending one, and you have already made $150, you can not be 100% sure which direction the stock price might move. So, in this strategy, buy a put on XYZ for a strike price at 70 and expiration of 6 months+. In our case, buy the put for the month of August or later. Say this costs you $800. This gives you a right to sell the XYZ stock at a price of $70, even if it drops below 70 by August expiration. (For a real time example, as of this article date - Feb 2006, see JOYG with current price at ~55, and its option chain with strike price of 60. Its Oct 2006 put was available at ~6.5)
Scenarios:
Let’s consider some scenarios to illustrate how this can be a low risk, high profit strategy.
Scenario 1: By the March expiration date, if the XYZ stock price goes above $75, the stock will be called out. That means it will be sold from your account. Normally, stocks ‘in the money’ by $0.25 will be automatically exercised.
Since the stock price has gone up, your put price will decrease. Since the put is in the future, its delta is low. You might be able to sell it for around $600. Higher the stock price goes, put price will decrease. You can wait for a good time to sell before its expiration. The net profit for 100 XYZ stocks can be calculated as follows:
Stock price sold – stock price bought + premium received from covered call – put price bought + put price sold.
i.e. 7500 – 6900 + 150 – 800 + 600 = 550. That is a return of 7.3% PER MONTH. Which translates to 87.6% per year.
Scenario 2: Stock price goes above 69, but remains below 75 by the March expiration. Here the call will expire worthless, and you get to pocket the premium received from writing the covered call. You can write another call for April for the same underlying stock XYZ, for which you may get $150 - $200. You can continue writing the covered calls until the protective put expires or you get called out. Your overall return could be 30% to 70% per year.
Scenario 3: In most trades, if the stock price drops, you lose money, but not here!
Let’s say, XYZ falls in value to $65 by March expiration date. If you had just traded only the stock, your portfolio would have decreased in value by $400. But, in our case, since you have the protective put, you can still sell the stock at $70, no matter how low the price drops.
If it is in later months, say April or May, you will have generated some income by writing covered calls. If the stock price goes down, there are two alternatives we can choose. Wait till the covered call expires for the month, or buy back the covered call. Before the protective put expires, you can either exercise the put, or sell the stock at current price. The protective put price goes up when the stock price drops. So you can sell the stock at the current price of 65 and sell the protective put at around 950.
Depending on the months elapsed, since you can write covered call each month, you will have made $200 - $600.
So, net for this scenario would be:
Stock price sold – stock price bought + premium received from covered call from all months so far – put price bought + put price sold.
i.e. 6500 – 6900 – 800 + 950 + 300 = 50. This will be just a breakeven, despite the stock price has gone down. If the stock price goes further down, there may be little bit more loss, but the maximum risk is the premium paid for the protective put minus money received from covered calls [minus/plus difference between the stock price and put strike price].
So, even if the stock price goes down, you will find yourself with a small profit or no loss or a very insignificant loss. You have, overall, a very good opportunity of cutting down your risks.
This strategy, in most cases, gives a good profit, and in rest of the cases, a very low risk. Thus, this is a high profit, low risk strategy. Practice the details and paper trade the strategy.
For a current list of stocks which fit this strategy, visit BeingLIVE.com/Stocks.html
Disclaimer: This article is published solely for information purposes and is not to be construed as advice or a recommendation to buy or sell a security. Trading results may vary. No representations are being made that utilizing techniques mentioned in this article will result in or guarantee profits in trading. Past performance is no indication of future results.
