Covered Call Downside Protection

Question - The main fear of covered call trading is downside risk. Do you think we need to buy a put for the downside protection of the stock in case of a sudden market crash or company specific stock crash ? Under what circumstances ,will you use a Put in covered call ?I understand that buying a put will reduce the premium received from covered call selling.



Answer

Great question.

Keep in mind that our approach to covered call writing is identical to that of the Sleep at Night put writing strategy - except we replicate the process with covered calls instead of naked puts.

So I'll answer your question in terms of the Sleep at Night Strategy and then I'll show you how that converts or applies to covered calls.

First off then, you're right - the biggest risk to the Strategy is the underlying stock takes a big dive.

But I would argue that what's really at risk isn't the permanent loss of capital as much as the inconvenience of an inefficient trade - assuming, of course, that we adhere to our trade selection, set up, and management principles and processes.



When we do that, we essentially have three layers of protection, three levels of protection:

#1 - Selection and Set Up - Because we strive to sell puts on stocks that are in "limited downside situations" (where we can ideally identify multiple reasons why the stock in question is unlikely to trade lower, or lower by much, in the near term), we should avoid a lot of problems right there.

Obviously there's no guarantee that all our trades will work out flawlessly.

That's unrealistic.

But our approach, by definition, guarantees that we'll never sell puts at a top. When we combine fundamentals, valuation, and technicals, even if a trade does go against us, our "pain" will be a fraction of what it might have been had we less disciplined selection and set up criteria.


#2 - Position Size - I almost always start every trade as a small position (we cover the subject of position size in Week 2 of the Sleep at Night High Yield Option Income Course).

A small initial position size gives us two key benefits:

  • More flexibility in managing the trade if it misbehaves
  • An important form of diversification (through time) so that we're less vulnerable to market-wide sell offs.

#3 - Trade Management Process - Our third layer of protection here is also our most powerful.

Specifically, I'm talking about the 4 Stage Short Put Trade Repair Formula in the event that our trades don't go according to plan.

The Repair Formula has been extremely effective for us. In fact, it has its own multiple layers of protection built into it:

  • It identifies the specific trade repair techniques to use
  • It tells us in what precise order to use them
  • To further maximize the effectiveness of the Repair Formula, we've also fine tuned the timing of our moves (covered in Week 5 of the Sleep at Night Course)

When you combine all this, we have a very effective (and very efficient in terms of capital usage) trade management process in place that's shown it can handle just about anything Mr. Market can throw at us.

(Providing we don't sabotage ourselves at the outset by overleveraging a position when setting it up, selling puts on overvalued stocks, unprofitable businesses, etc.).



The Sleep at Night Strategy for Covered Call Writers

Now, everything I wrote above applies 100% to our covered call writing approach. Again, unless dividends are involved, it's the identical strategy.

So whatever strike we would choose for selling a cash-secured put, we would choose the same strike for a buy-write covered call.

And the current share price would make no difference.

Here's what I mean . . .

Say the stock is trading at $30.50/share and we sell a $30 put for, say, $0.60/contract.

On the covered call side of the equation, we would do a buy-write and acquire the shares for $30.50/share and sell a $30 covered call for a price that would likely be somewhere around $1.10/contract.

(The math: $0.50/contract of that $1.10 amount would be intrinsic value - which would be a wash assuming the stock continue trading above $30/share so that our $30 covered call gets exercised against us at expiration and we sell our $3050 stock for $3K - plus $0.60/contract of time value, or the comparable amount of time value as that of the $30 short put.)

In fact, the entire process is the same - from the selection and set up process to our position size to how we manage the trade once set up.

It's just inverse to the put writing form of the Strategy, or as I describe it in the Ultimate Covered Calls Course inside the Leveraged Investing Club, a mirror-image trade.



Should We Add a Protective Put to Our Naked Put and Covered Call Trades?

Now, regarding adding more traditional types of downside protection on a trade, such as buying a put, I cover a bull put spread approach to acquiring discounted stock in the Essential Leveraged Investing Guide (my ebook included in the Library Section of The Leveraged Investing Club).

In particular, I discuss incorporating bull put spreads vs. cash-secured puts (which is essentially what you would be doing if you bought a protective put on a short put position).

And again, if you go the covered call route with the trade, you could achieve the very same purpose by buying a put at the same strike that you would on the regular Sleep at Night put writing trade.

It might look a little weird, but it would function essentially the same.



A couple of comments about buying a protective put (at a lower strike than where you either sold your naked put or covered call) . . .

First, our approach to bull put spreads (or the covered call equivalent) is very different to how most traders view them.

We're still (and always) in campaign mode, not a "trade as a one time event" mindset.

So if the trade goes against us, we don't view the bull put spread as defining our "maximum loss."

That's because we have no intention of booking any kind of loss at the end of the day.

So what a bull put spread (or out of the money protective put added to a covered call position) would do for us in the event of a sell off, is limit the current damage Mr. Market otherwise would have subjected us to.

It means our position will be less underwater than it otherwise would have been, and in the case of a major sell off, it would end up making the trade a lot easier to manage and repair.


But - and this is my second point - that potential protection comes at a cost.

As I say a lot, options are always about trade offs, and this is a perfect example.

If we view selling puts as a form of selling insurance, then buying a protective put at a lower strike is a form of "re-insurance."

(Which is a common practice in the insurance industry where underwriters frequently buy their own form of insurance in the event of a truly catastrophic event).

So you're giving up a portion of your potential returns in order to minimize the impact that the occasional trade blowing up on you will cause (and again, this is all applicable to writing covered calls as well).



Ultimately it comes down to personal preference whether you incorporate protective puts into your put writing (or covered call writing) operations.

I rarely use the bull put structure with my own naked put trades, but I'm also very comfortable with our trade management and repair process.

But I can certainly see the case for doing so (again, we're not overleveraging with bull puts but treating them as naked puts with a form of re-insurance tacked on) when it comes to certain types of trade.

For example, any trades I make that has a lot of commodity or currency exposure - e.g. oil, gold, etc. - I'm more likely to add a long put into the mix.

Commodity type trades don't follow the same rules as regular business operations - commodity type trades can take a LOT longer to bottom and they can go down a LOT more than regular stocks.

(E.g. the trades that have taken me the longest to repair have been in the energy sector - long puts would have been very welcome with those trades!)



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