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This is a continuation from “Part One” of a three-part series.

Covered Call Ctd.

It’s rarely a good idea to sell a covered option if your stock position has already moved significantly against you. Doing so could cause you to establish a selling price that ensures a loss. To avoid locking in a losing trade, before you sell a covered call, always ask yourself the question, “Would I be happy if I had to close out my stock position at the strike price on this option?” If you can answer yes to this question, you will probably be OK.

Remember, if your short option is in-the-money, you can be assigned at any time. This is especially common on the day right before the ex-dividend date and anytime during the week of option expiration.

The Collar (Long Stock, Long Puts & Short Calls In Equal Quantity)

This is a strategy that combines a covered call and a protective put. Consider establishing a collar if you are primarily concerned with protecting a position at minimal expense. A collar provides temporary protection against a downturn in the equity position, but also removes most of the upside potential.

Since it’s generally unwise to hold a long stock position if you think the long-term prospects are poor, you should only consider employing this strategy if you feel the long-term prospects of your stock are still favorable.

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Probably the biggest benefit to trading a collar is that it can often be done for little or no out-of-pocket expense, because the proceeds received from the sale of the covered calls can be used to finance some or all of the purchase costs of the protective puts. In some instances, you may even be able to receive a net credit. Unlike many other option strategies, collars tend to get less expensive as you go farther out into the future.

The most common use of a collar is to protect an unrealized profit when you are not yet ready to sell the position. A properly structured collar can help protect against a downturn while attempting to postpone capital gains obligations.

Since collars are best structured so that both the puts and the calls are out-of-the-money but have the same expiration date, the ideal situation is for the stock to increase just slightly (but not beyond the strike price of the call) after the collar is established. This will result in both the put and call options expiring worthless and a small gain on the stock.

Assume you purchase 1,000 shares of XYZ at 52, and the stock rises to 72. You may be optimistic about the long-term prospects of this company, but in the short term you are a little worried. Since you have a 20-point unrealized gain in this stock, you are willing to risk a 2-point downward move, but you want to be protected against anything greater. You think the long-term outlook is good, but you do not expect any major upward price movement in this stock in the near term.

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A protective put could provide the downside protection you seek, but if there were no downward move, the premium you paid would be lost. A covered call could provide limited downside protection and could even generate a little income, but you could still lose all of your gains if there were a substantial drop.

A stop order below the current price might protect you, but if the stock gapped down at market open, you could have larger losses than you expected and you would end up selling your stock. If your primary concern is just to hold steady without spending a lot of money, without selling your stock and without getting clobbered, a collar may be an effective strategy.

Assume you establish a collar by selling 10 XYZ 75 calls at 2, and purchasing 10 XYZ 70 puts at 2. Your total out-of-pocket expense will be only the commissions charged by your broker. When we display all three positions on a graph, we can see that at expiration the breakeven point is 72 (the current stock price). If the stock drops to 70 or below, you will not lose more than $2,000, but if the stock increases beyond 75, you also will not gain more than an additional $3,000.

If the stock drops below 70, to avoid exercising your put options, you could sell the puts at their market value. The proceeds from the puts should offset all but 2 points of the loss on the stock. If the stock rises above 75, to prevent the assignment on your calls, you could buy your short call options back at the market price. You would probably lose money on the call options and the loss would eliminate all but 3 points of the gains on the stock.

Part three of this series will cover cash secured equit puts

If you enjoyed this article, check out Part One and other articles by Randy Frederick at “The Options Insider” Web site.