What do you think of this strategy? My broker has tried to talk me into this kind of transaction in the past and I just wasn't comfortable with it. Is it worthwhile?
Hedging With Calls
When market conditions create rapidly fluctuating stock prices, an investor may look for a more cautious approach to market participation. One solution is the Protected Covered Write, which will be referred to as a "Hedge Wrapper." This strategy is also known as a "Collar."
A hedge wrapper entails the purchase of common stock, the sale of an out-of-the-money call, and the simultaneous purchase of a protective put.
This strategy is a combination of the properties of a covered write and a put hedge. Upside potential allows for incremental returns. Downside risk is eliminated for the life of the contract, below the strike price of the put, as the put holder is entitled to sell the stock at that predetermined price.
Let's look at an example which provides an idea of possible risk/reward scenarios:
Buy 100 Shares XYZ @ ($34 per share) = + 34
Sell 1 Six Mos. 40 Call = - 2
Buy 1 Six Mos. 35 Put = + 3.70
Net Debit = 35.70
For simplicity's sake, this example does not include transaction costs, which have a significant impact on the outcome of option strategies.
Assume that with 6 months to expiration, XYZ will pay 2 quarterly dividends of $.25 per share prior to expiration. Note: there is no guarantee that the dividends will be received, as it is possible that the short call could be assigned (the investor is obligated to sell the stock at the strike price) prior to the stock going "ex" the dividends.
In this example, the investor has defined maximum risk and maximum reward. The following conditions result:
Maximum Risk
(Stock at 35 or below at expiration, the investor exercises the put.)
The purchase of the put has assured a minimum selling price of 35 on the stock until expiration. The net cost on the position is 35.70 therefore, the maximum risk is .70 before dividends (.20 if both dividends are paid) and transaction costs.
This example assumes the investor would close out both option positions at the same time.
Maximum Profit
(Stock at 40 or above at expiration, the investor's stock is called away.)
As in any covered write, the maximum profit would be realized with the stock called away at the strike price of the call. In this case, the investor would sell stock at 40, which creates a profit of 4.30 before dividends (4.80 if both dividends are paid) and transaction costs.
Break-even
The dividends the investor may receive prior to expiration may be viewed as approximately 1/2 of a point in income. This would lower the cost basis of the position to approximately 35.20 . Transaction costs must be added to that figure to arrive at an actual break-even point. With the stock between 35 and 40 at expiration, the long put and the short (covered) call would most likely expire unexercised. The investor would have a loss on the put premium paid, and a gain on the call premium received, and would continue to own the stock unencumbered and unprotected. At this point, the stock could be sold out, held alone, "re-wrapped" with both a new long put and short call, or become the subject of either a put hedge or a covered write, depending on the investor's outlook at that time.
An investor might notice as a matter of course that the maximum rate of return on a hedge wrapper is lower than on a covered write, as a result of the premium paid for the put. It follows that an out-of-the-money put, for example, could allow for higher potential returns as it would cost less in premium. An out-of-the-money put also provides less downside protection, thereby increasing the risk percentage in the position. This strategy may be tailored according to an investor's risk tolerance and upside objectives.
