Basically, what you’re doing is, you’re going in and you’re buying a covered stock scenario. We’re going to do 5 shares here – 500 shares, and 5 contracts.
You can see that it’s just the opposite of a covered call strategy. You have unlimited upside potential, and very limited downside risk. Let’s un-check this, and go back to our covered stock, or covered call position. You can see that we have limited upside potential, and unlimited downside risk, which is just the opposite of what we want to do. With our covered stock position, by buying the put and buying the stock at the same time, we have very limited downside risk, and unlimited upside potential. That’s really what we want to do.
Now, there are strategies, like I mentioned, where you can use a call strategy against your stock. We start out with a covered stock position. We have our covered stock on. At a higher strike price, we sell some calls against that. What that does is help you offset the premium of your insurance. Your $17.50 calls are going to cost you 55 cents, for each of the calls that you’re buying. You can use the sale of the $19 strike price calls to help offset that cost.
Let’s go ahead and analyze that. What that does is basically bring a graph like this, in which you have a limited downside risk, and you have a limited upside risk, because you sold a call against your stock. Some people like this strategy. I don’t particularly like this strategy, and do not employ this strategy.
There are strategies in which it does help to pay for your long put by selling the call against your stock, but the limited upside potential is not particularly attractive to me. Also, there are strategies that, if you do this, and the stock does not move, or it does move up slightly – you can generate some income doing that.
I prefer not to have that. I would rather have limited downside risk, and unlimited upside potential. I only want to pick stocks that are going to move, and move in either direction is fine with me. I would prefer it if they move up. In some cases, they don’t move at all – in which case, I lose a little bit of my insurance.
That’s just me. You can do this collared position. When you sell a call against your put, that you’re buying for insurance, it’s called a collared position. You have to be careful, though, that you do not sell a call at the same strike price as your put. If you sell a call, and you buy a put, that is a synthetic short position. Just like stock, you would be synthetic short of the stock, at the same time that you’re long with the stock. It’s called a conversion.
Let’s see what happens to our graph, if we should actually sell the $17.50 call here. You can see that we have locked in a loss of $335 here. We cannot make a profit on that position, because we’re short the stock and long the stock at the same time, at the $17.50 price level.
If you do this collared strategy, make sure you use a strike price that is higher than the put option that you are purchasing. If you wanted to do something that was in the money on the put side, you would have to go up to the $20 strike price, on the call side, in order to make this an effective strategy.
Like I said, I don’t like collaring stock, only because I’ve lost the upside potential that I’m really looking for. I’m only interested in purchasing stocks that have some movement potential, either to the upside or to the downside.
That is not a great strategy for me. Collared stock and covered calls are not particularly attractive. Some people are asking me, “How do you pick the stocks you are interested in using for this strategy?” You know, if we’re going to be doing this type of strategy, obviously, you want to have a stock that you believe in. You want to have a stock that actually has some upside potential to it.
Yes, you have your insurance in place, and you know what you need to do with your insurance, in case the stock goes down. You cash in your policy. When stock moves down, your put will actually increase in value. You’ll be able to cash that in, to generate some additional cash. Not just to buy more insurance, but to buy more shares. That’s how you can leverage this.
It’s almost like a pyramiding effect. You pyramid your winnings in your insurance policy, in your put, and put it back into the stock to buy more stock. There’s no more money out of your pocket to buy that stock. Now you have a larger position. If the stock does rally, you can exponentially increase your earnings, and increase your profit potential on that stock. That is really a fantastic deal.
It doesn’t matter if it goes up or down. All we want with this kind of stock position, is for the stock to move. We want it to move down. We want it to move up. We just want it to move. We don’t want it to sit there. That’s why I said – if we have a position like Starbucks, if we bought the stock over here, and we’re sitting here a month later, and it’s still $17.50, the price we bought it… Maybe the potential for that stock has decreased somewhat. We may want to get out of it.
If you think it has potential to move, then you might want to reinvest in another month of insurance. I wouldn’t give it more than a month, or two months, at the most. If a stock hasn’t moved by that time, I’m out of that stock, and I’m into another stock.
Now, how do you get stock ideas? There are a couple of different ways. One that I prefer is to use the Investors’ Business Daily, IBD 100, stock list. I use the IBD Big Cap 20, which comes out on Tuesdays. I also use the IBD 100, which comes out over the weekend, and is updated every single week.
Either one of those lists – I would say that the first 15 or 20 stocks on each one of those lists are excellent candidates to do this kind of strategy with. There are other places that you can look, obviously. The IBD 20, the Big Cap 20, and the IBD 100, are really excellent candidates. Those are the strongest stocks that Investors’ Business Daily has identified in the marketplace, at any one given time.
Another rich source of ideas is Baron’s, which comes out weekly. Also, the Wall Street Journal. Once in a while, I read the Wall Street Journal. I kind of like the lists of the IBD 20, which are the Big Cap stocks. That gives you the larger stocks, and the universal stocks – they have larger trading volume, which is important for liquidity.
I don’t like to get into a stock that trades less than a million shares a day. I prefer stocks that trade anywhere from a million and a half on up. It does provide extra liquidity for your trades. Also, there are usually a lot of good options available, on the exchange, or the stock itself.
For example, let’s take Starbucks. Starbucks has pretty liquid options. You can tell if they’re liquid not even by looking at the volume, but by looking at the bid-ask spreads. The at the money July options has a 2-cent spread. They’re bidding 44, and they’re asking 46. That’s a pretty tight spread for a stock.
If you take a look at something like EDU, which is a Chinese company – the at the money July options has a 20-cent spread between these two. That’s a little bit more volatile stock. Still, a 20-cent spread is pretty big. If you take a look at something like SWN, which I’ve been following, it’s a 10-cent spread.
I don’t mind a 10-cent spread between the bid and the ask at the at the money options. But once you get to the point where they’re like 15, 20, 25 cents… I’ve seen even worse, on some stocks. The question is – let’s go through the Big Cap 20, for the IBD again.
They have some of the biggest stocks, that have some of the greatest fundamentals.