This post originally discussed a variant of a covered call strategy to be taught at my March 10/11 seminar, which has come and gone, so I have updated it to deal with emails received. Comments generated were eliminated since they are not applicable to the revised post.

This strategy involves writing a covered call and adding a protective put (known as a “married put” when the put is part of the trade at entry). The put can be NTM or ITM and will typically have an expiration several months out, perhaps the nearest LEAPS put. The concept is to write calls against the stock with the long put backstopping the trade. The downside risk in the trade is the amount the trade’s net debit exceeds the put strike.

Suppose we buy NSM today (April 5 as I revise this post) at $24.64, write the May 25 Call for 0.90 and buy the JAN-08 25 Put for $3.10; our downside risk is $1.84 (26.84 net trade debit - 25.00 strike) - or 6.8%. The simplest approach is to keep writing NSM until called. And if called, buy it again and keep writing. This is of course an oversimplification, since we can trade the calls, trade the stock, etc. Once we pull in an additional 1.84 in credits from trading or option writing, the trade begins to make money. Any transaction that would yield a profit or gain in a covered call trade adds to the stream of credits generated, and any transactional loss adds a debit.

The protective put construction eliminates risk once enough premium or trading gains are brought in to recoup the put premium. In the foregoing example, there is no downside risk (other than generating trading losses) unless you wind up buying NSM at some point above the 25.00 Put strike - which might leave an exposure gap above the put strike.

The ITM put, a little different animal, eliminates downside risk once enough premium or trading gains are brought in to pay the time value in the put - of which there ideally will be very little. If the stock falls, keep writing it, or buying it again and rewriting it. The goal ultimately is to sell the stock by exercising the long put, which recoups the put cost.

The risk in the ITM put construction, interestingly, is that the stock moves up too much. Assume in the NSM example that we bought the JAN-08 30 Put instead of the 25P for 5.90 and NSM gapped to $35 and stayed there, or kept moving up. We would be called out at the 25 Call strike, and the ITM put that cost 5.90 would be seriously OTM, with a greatly reduced value - probably a 1.00 or less. We might eventually trade our way out of the situation, but this would not be a fun position in which to be.

At the appropriate time, either exercise the put to sell the stock or sell the put itself, depending on where the greatest advantage lies. Obviously, the trader can do a lot to engineer strikes to achieve more or less return, with corresponding risk levels, in any put-protected covered call write.

The new “portfolio margin” rules discussed in other posts will really power this strategy to the moon. On April 2nd the new rules came into effect, which base available margin on the portfolio’s risk. It will be possible to run a covered call trade with protective put, putting up only about 5% of the trade cost. The long-term married NTM put eliminates all but a small portion of the risk and will be ideal for using portfolio margin. The ITM put still will pose a risk as noted above that is substantially higher.

Please don’t get misled into running a trade with inappropriate risk levels using too much PM margin simply because you can. Inexperienced traders focus on how much they can make; experienced traders on how much they can lose.

Before everyone takes me to task on the “nearly riskless” language, I understand that there is no truly riskless trade. Shareholders can be wiped out in a bankruptcy reorganization, for example. I have seen traders turn a problematic but salvageable trade into a disaster by poor trading, and have done that myself. Any put-protected covered call strategy relies for ultimate profitability on generating a stream of credits from option writes or trading gains (or both) that exceed the total debits. Trading losses generated while in the trade will either eat up some of the return or result in a loss. And these trades are not “riskless” to the downside until the cost of the put has been recouped.

I will be writing more on the subject from time to time. You might be interested to know that we have been playing with this strategy for a while now (I had always pooh-poohed it as like watching paint dry) and are working on new lists both for current-month collar trades and covered calls with long-term protected puts. We are experimenting to see what parameters yield the most useful trades. These trades are becoming of greater interest because of my belief that a new bear market could be in the offing. Stay tuned.

I understand that puts have been around for a long time, since about 1977. Buying long-term protective puts, both for covered calls and long stock, has been around about as long. This strategy is nothing new and I certainly can make no claim to having invented it (no one could honestly claim that), although my approach - especially to trade selection and execution - is not the same as anyone else’s.

I have bought long-term puts quite a few times to protect covered calls and have bought long-term calls and written current-month calls against them. I have been burned buying long-term ITM puts after a covered call position fell and I averaged down, because the stock came right back.

Every strategy works if done right. Protective puts are just another tool (whose cost must be recouped), and they are by no means required in order to write covered calls with consistent profitability. But if you like the idea of using protective puts as essentially a stop loss technique - where you know the maximum possible loss going in - some variant of this strategy might just be for you.

This entry was posted on Monday, March 5th, 2007 at 2:27 pm and is filed under Covered Calls, Trading Tips. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.