After first reading about this idea first on Quora and then on Youtube, we have went through different scenarios to find the flaw in the strategy. The strategy is capital intensive but it appears to have such a good payout that it makes sense investigating.
- Buy long shares of a liquid stock (possibly an ETF to avoid earnings issues)
- Sell Calls that are just above the current price to collect premium. Do this each month.
- Buy a Put that is 2 years out (which makes it a LEAP). This put buys you protection for a decline in the stock.
- If the calls get exercised, you just buy the stock back and keep going. That situation nets you extra profit for that month. According to TD Ameritrade, the stock is not likely to get exercised if it hits expiration right around the price, within a point or two.
Questions: We think that if the stock price goes down below your original stock purchase price, and then gets called away (leaving you with no stock, but holding the put that you bought for the future date), you would need to purchase the stock back immediately, as close to the price at which you lost it at (the call strike price). What happens if the price is way above your call? You lose the differential between the call and your original purchase price? Does the Put that was purchased come into play?
Scenario that we don’t understand:
Bought 1000 shares of a 100 stock, which equals 100,000
Price goes to 80 in any month, and you sell a call at 81.
During the month, the price goes up to 85, the stock gets called away from you.
Problem is, you are in it at 81 (where your call was), so you’d have to buy it back at 81000 investment to continue executing the covered call end of the strategy. This means 19k (minus any premiums received) out of pocket. Where we have a difficult time understanding the strategy in this situation, is that we don’t believe/know that you can exercise the put option at this point (prior to expiration) because a) it is before expiration b) you could only do it once? This needs to be understood.
*On further thought #1 – We believe that the option can only be exercised one time, so we wouldn’t want to exercise it early. Maybe, we just buy back the stock wherever we can (we have a loss on paper…but this is rectified at the put options expiration). Most likely the difference between our exercised call strike and where we buy back the stock is our risk. We’d endure that risk every month. Hopefully the premiums make up for it. If the stock is less than our protective put at expiration, not a problem, we sell the stock for that price. If the stock price goes above our initial purchase, still not a problem, our put option will expire worthless, and we will earn the difference between the original purchase price and current price.
Maybe one way of handling the above is to do the collar on an ETF and the ETF’s inverse…so that you essentially create your own insurance on the whole scenario. Maybe it wouldn’t even require purchasing the Put?
*On further thought #2 – If the stock is called away from us at a lower price, but significantly above our strike price (leaving us stock-less, and not close to expiration, and with a gap too big), we can sell puts until we own the stock again. Selling near the money calls is really the ideal, but we can take the lower income until we own the stock again, and brought down our cost of the stock, and then continue with the strategy.
Some examples that we worked out where the calls would be bought at a 1 std deviation OTM:
ADM (example with dividend)
Current Price @ 46.07
Sell JAN – 48 Strike (70%) pays $.90 = .9*100*12 = $1080
Buy JAN 2018 45 Strike (45%) costs $4.50 = $450
Dividend = 2.6% = 1.20/share
Net = $630 + dividend ($120) = $750/year per contract
ROC = 750/$4600 = 16.3%
MU (no dividend)
Current Price @ 20.35
Sell JAN 22 Strike (75%) pays $.43 = .43*100*12 = $516 Credit
Buy JAN 2018 17 Strike (44%) costs $1.95 = $195
Net = $321/year per contract
ROC = 321/2000 = 16%