Covered call writing trades can be crafted to be aggressive or defensive. Cautionary approaches include writing in-the-money (ITM) call strikes and adding protective puts to the covered call trades (converting the covered call trade to a collar trade). The former is free and paid for by the option buyer in the form of intrinsic-value premium. The latter is paid for by the option seller (that’s us) and will reduce our overall returns. In this article, a real-life example with NVDIA Corp. (Nasdaq: NVDA) will be analyzed using both approaches.
NVDA call/put option chain on 11/27/2024 for the 12/27/2024 contract expiration
Free insurance: The ITM call strike
ITM call strikes consist of both time-value and intrinsic-value (the amount the strike is lower than current market value). This results in a lower breakeven price than at-the-money or out-of-the-money call strikes, or additional insurance to the downside. This is paid for by the option buyer (not us) in the form of intrinsic-value, With NVDA trading at $132.67, the ITM $130.00 strike shows a bid price of $7.40 (pink row, green arrow).
Free insurance calculations
- If taken through expiration, this is a 31-day trade (red circle)
- The initial time-value return is 3.64%, 42.84% annualized (brown cells)
- If exercised at the breakeven (BE) price of $125.27-yellow cell), the NVDA is purchased at a 2.01% discount (purple cell)
- This additional protection to the downside is paid for by the option buyers and free to us, the option sellers
Insurance we pay for: The collar trade
There are 3 legs to this defensive approach to covered call writing:
- Long stock (NVDA: $132.67)
- Short call (sets a ceiling on the trade- maximum gain- $134.00 call at $5.30): Brown row, red arrow
- Long put (sets a floor on the trade- maximum loss- $128.00 put at $3.45): Yellow row, red arrow
- The trade is structured to start with a new option credit ($5.30 – $3.45 = $1.85)
Insurance we pay for: Collar calculations with the BCI Trade Management Calculator (TMC)
- The net option credit ($1.85) is entered as the option premium
- The BE is higher than the free insurance at $130.82
- The initial time-value return is lower (1.39%, 16.42% annualized- brown cells)
- We have a defined maximum loss at the $128.00 put strike
- There is an additional upside potential of 1.00% (purple cell) if share price rises to or above the $134.00 call strike
Discussion
- The collar strategy adds a protective put to our covered call trades
- Protects us against overwhelming share price decline
- Time-value returns will be lower in exchange for the added protection
- Our collar trades can be managed by the BCI Trade Management Calculator (TMC)
- We do so, by deducting the put premium debit from the call premium credit
- We can establish both initial and final calculations using this spreadsheet
Covered Call Writing Alternative Strategies
Covered call writing is a cash-generating strategy that lowers our cost basis thereby improving our opportunities for successful investments. One of the many benefits of incorporating this strategy into our investment portfolios is that the system can be crafted to meet our trading style, market assessment, portfolio net worth and personal risk tolerance. This book details three such covered call writing-like strategies that will highlight:
Portfolio Overwriting- using stocks in buy-and-hold portfolios
The Collar Strategy- using protective puts
The Poor Man’s Covered Call- using LEAPS options
Click here for more information.
Your generous testimonials
Over the years, the BCI community has been incredibly gracious by sending our BCI team email testimonials sharing stories as to what our educational content has meant to their families. Moving forward, we have decided to publish several of these testimonials in our blog articles. We will never use a last name unless given permission:
Hi Alan,
Many thanks for this.
Gee, isn’t the market horrible ATM…
(I’m in XOP and BAC – I’ve been trading Crude (via CFDs – they are legal in Australia) for a couple of years, (hence XOP), and I like the fundamentals of BAC. Both are down, but The Wheel allows us to make money even when we’re (in my case) absolutely wrong!
It’s such a powerful strategy. (I’ve closed my CFD account and put the funds into The Wheel. Gee, I would hate to think of the carnage I would have made of my account if I had an open Crude position now!) So, thanks for all the great online material and books! Your books on Covered Calls and Cash Secured Puts are tremendous.
Many thanks for your great service.
Cheers,
Stuart
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