Hello, tradeologists. We left off Part 1 with talking about covered stock. That is the purchase of stock with a put option for insurance, in case the stock doesn’t go in the direction you would go in, which is up.
Let me explain to you that it doesn’t matter whether the stock goes up or down. We try to avoid the hassle of it going down. We would rather have it go up. Yes, the insurance is a cost, and it does cost us money to put on that insurance, but it’s well worth the cost. I think you would agree. If you’re buying 1000 shares, even if you’re only buying 100 shares, that one put option on your position does let you sleep at night. It gives you some comfort, in knowing that if the stock does decline in price, or open up dramatically lower the very next day after you bought it – and it’s happened before. It’s happened to me.
You won’t lose a lot of money. I put a cap on the amount of money I want to lose upon initiating the position. At that point, either I cash in my insurance policy to buy more shares. Or, what I do is, if the stock goes up, I’m in a happy situation, and I roll those puts up as the stock increases in price, so I’m protected at higher levels.
I may not set it as close. I may not set that put as close. If I bought the stock at $18, and I put a $18 put on there, at the strike price of $18, if it rolls up to $19 or $20, I might only roll that put up to the $19 level, instead of the $20 level. I have a built-in profit, at that point. I’m always rolling up my puts underneath the stock price, so that I have that additional protection, as the stock increases in price.
At some point, that stock may decline again. I certainly want to be able to use that put as insurance, to cash in and buy some additional stock, at that point, and continue with the trade.
That’s the real benefit. Here’s a good question: What happens if the stock doesn’t do anything at all? Let’s say you purchased it here, at $17.50. Let’s go back to our Starbucks chart again. You purchased the stock at $17.50, and it meanders and doesn’t do anything. About a month later, you’re still at $17.50.
I’ll pay one month of insurance on a stock, and if it doesn’t pay off, or the stock doesn’t move, then I don’t really want to hold that stock anymore. I will go into something that’s a little more active. I will only hold a position like this – let’s say I bought this at $18 now, and I put an $18 put on as insurance. I’ll hold that for a month. If I have to go back in, and the stock has not moved, and it’s still at $18, and I have my $18 put, it’s going to expire worthless.
At that point, I’m going to call it a day and say, “Hey, you know what? This stock isn’t going to move.” Unless something happens in the stock beforehand – unless I think it’s about to make a dramatic move upward, I may stay with the stock a little bit longer. Generally, I’ll give it a month to move. If it doesn’t move either up or down, then I want to look for other opportunities, free up my capital, and put it into something a little bit more opportunistic, with a little bit more potential.
Also, there are other strategies that you can take advantage of. We’re going to go out to July here, in this timeframe. Let’s say that you wanted to buy Starbucks. You really wanted to hold it for the long term. You didn’t know whether or not it was going to go up immediately in price or not.
One of the things that you can do in order to pay for your put option… Let’s say you buy the stock at $18.40, where it is today. You purchase one of the $17.50 strike put options. In order to help defray the cost of that put option, you can also sell a call against it. It’s very similar to a covered call strategy, in which you buy the stock, and sell the call at a strike price a little bit higher than the current cost of the stock. If the stock is at $18, and you sell a call option at $19, it’s called a covered call strategy.
Let’s just go ahead and do this. Do they have that in here? They have covered stock. They have a collared stock. I don’t even know if they have that in here, because frankly, it’s not a very good strategy. Someone else had asked me, in the course, about it. It’s not a particularly attractive strategy. Let me show you why.
If I go in here and I go ahead and buy the stock – let’s say I buy 500 shares. I’m going to go ahead and sell these, which would be considered a covered call here. We’re going to do 5 and 5 – 500 shares of stock, and sell 5 of the $19 calls.
Let’s go ahead and analyze this. I’ll show you why this is not a particularly attractive strategy. What the covered call writer is hoping you’ll do is to capture the premium here, on the $19 strike price call. On 5 shares, you would be able to capture about $200 or so in premium on that, if the stock does not move.
If the stock moves up to $19, which is your strike price on your call, you’re going to make a few hundred dollars. At $20, you’ll make about $400, which is pretty much the cap. Well, maybe $600, at the very most. The problem with that kind of strategy is that you have no downside protection whatsoever.
You can see that the downside to the stock is basically unlimited. If the stock continues to go down, you have an unlimited loss on the downside. That’s why I do not suggest a covered call strategy. Covered call strategy is the same as just a regular old call. If we go into Starbucks again, and buy this call here, and analyze that – you can see that you have downside limited risk, and you have upside potential.
If you sold that call, you would have a mirror of what you just saw with the covered call strategy. You would have limited upside profit potential, but unlimited downside risk, if the stock continued to go up. The exact same chart that we just saw would happen if you sold a put against that. You would have the identical graph, which is a limited upside potential profit, and an unlimited downside risk.
The covered call strategy – let me just show you that again. I wasn’t able to put both of those up at the same time. We purchased the stock. At the same time, we sell the calls against it. In this case, we’re doing 5 calls, sold against 500 shares of stock.
You can see that there is limited upside potential, and unlimited downside risk, to that position. This was opposite to what we did when we sold the call, but if we sold a put, you basically get the exact same graph.
That’s the graph of a naked short put. The naked short put, and a covered call strategy, have the exact same profit and loss graph. In other words, when you do a covered call strategy, it is equal to selling a naked put. Selling naked puts can be very dangerous, especially if you’re in a down market. You can get killed. You can have unlimited losses on that put. You can see that there is very limited upside potential, and very limited profit potential, if the stock should move up. There are unlimited losses on the downside, if the stock goes down.
That’s why I don’t recommend covered call strategies. It’s the same thing as selling a naked put, which is a very dangerous technique to use. What we’re trying to do instead is limit our downside risk.
Let me show you that graph again. It is helpful to look at pictures. It helps to determine what you’re doing.