Last week, I showed you two ways to make money when interest rates go up.
The first offers the potential for unlimited gains.
The second allows you to buy expensive stock without risking all of your money to do so.
Both of these are great ideas, but readers have been asking why you can’t have both.
You can.
And all you need is your “collar…”
Combining the Power of the Covered Call and the Married Put
Before I show you how to combine covered calls and married puts for maximum protection, I want to quickly recap what they are and when you’d use them.
Covered Calls:
- You already own the stock and are selling the right to buy your stock at a specific price on or before a specific expiration date
- You’d use this strategy when you want to generate monthly income by selling call options against your stock
Here’s an example of a covered call trade, using my own tools. It could look slightly different depending on the broker and trading platform you use:
Married Puts:
- You buy the stock and an at-the-money or out-the-money put to protect yourself
- You’d use this strategy when you want to buy stock without losing your capital
And this is an example of what a married put looks like, again using my tools:
Now both of these strategies are already great ways to protect your money whenever the Fed actually decides to raise rates. But when you combine the two of them, you’ve created an even more powerful play.
And it’s called the “collar trade.”
A collar trade is formed when you already own the stock and buy at-the-money or slightly out-of-the-money puts while selling slightly out-of-the-money call options at the same time on the same order ticket. Both the put and call options must have the same expiration month and must have the same number of contracts.
This is ideal to use when you want to significantly lower your risk against falling prices but are still conservatively bullish. And the best part is that you shouldn’t need to exit the trade early because there’s very little (and in some cases, zero) risk.
Now you can use this strategy when you want to buy stock, and it’s also great to use after run-up in price of any stock you already own. Not only does it give you the chance to lock in your profits – it also doesn’t require you to sell your stock first. That way… you can leave yourself open to more upside gains while having that stock positioned to protect you against any depreciation in price.
Collar trades typically work best over a longer period of time (between one and two years), but they can work in the short term, too. The reason they tend to work better in the long term, though, is that you have more time for the stock to move higher, thus giving you higher yields.
Here’s a look at shorter-term collar trade using October, week three, options:
Here, you’re buying the October $58 put for $1.45 and selling the October $59 call for $1.01, so you’re now only out $44 per contract (-$1.45 + $1.01 = -$0.44 x 100 shares = $44).
Now keep in mind that this is really a protection play, and your maximum reward is limited. So you don’t want to use it if you’re looking for crazy returns. However, your risk is little to nonexistent.
In a sense, you’re helping pay for the cost of the insurance from the married put by buying-to-open the put optiob in case the stock drops. You’re selling-to-open the call option (idealling for about the same price as the put) in order to offset the two. This basically gives you insurance on a stock that barely cost you any extra out-of-pocket cash to begin with.
Now if you’re not a fan of capping your upside profit potential, especially after a nice surge in your stock price, you can always “opt out” of writing the calls and just go with the protective put insurance.
Just remember that the collar trade is your best consideration for having the stock market pay for most, if not all, of your portfolio’s “insurance.”
Here’s Your Trading Lesson Summary:
- A collar trade is created when you own the stock and buy at-the-money or slightly out-of-the-money puts while selling a slightly out-of-the-money call option at the same time – on the same order ticket. Both the put and call options must have the same expiration month and must have the same number of contracts.
- A collar trade offers protection against falling stock prices – with little to no risk.
- By writing an out-of-the money call against your stock, you stand to make capital gains if the stock price goes higher than the call’s strike price. Keep in mind that there’s a chance of your stock being sold (called away from you).
- Your maximum risk limited or nonexistent (the price of the stock + the price you paid for the premium – the strike price of the pu option – the price you paid for the call option)
- Your maximum reward is limited (the strike price of the call option – the strike price of the put – the total risk of the trade.
- There should be no margin requirement because you’re selling a call option.
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I’ll talk to you again soon…
Good trading,
Tom Gentile
