Today we’re addressing an insightful question from Ryan that was initially posted in the clubhouse. There’s a lot to unpack so let’s first look at the entire query below:

“Is selling out of the money covered calls to finance the cost of a long put hedge on IWM realistic? I have been routinely finding that the premium is so low on the covered calls that it is not worth it. Today I simulated a trade in which I bought 100 shares of IWM at $150.66. I then bought a 17 Jan 2020 136 put for $5.21. This places my break even at around $130.70 or 16% drop in IWM (break even = strike price – premium paid on long put). Not a very good deal, because buying the long put ends up being very expensive over time, which negates any protection since IWM is going to be up longer than it is down based on historical trends. Consequently, I looked at selling really far out of the money (FOTM) covered calls to cover the cost of the premium of long put, so that my losses are more realistically capped at IWM dropping to $136 rather than $130.70. However, I would not sell a 30 day covered call with anything less than a 160 strike price, which is above the 200 day MA based on technical analysis. However, the premium is only about 14 cents on an 18 Mar 19 covered call. However, I would need to make about 40 cents each month to cover the cost ($521 long put premium/12 months=$43 per month). However, based on the risk graph if the price hits $160 then I would incur a $220 maximum loss making the covered call a 1:11 reward: risk ratio. Sure, there are times when selling FOTM covered calls would be worth it, however, I am finding the same risk setup time and time again for many many months. Therefore, some other sort of other cash flow system (or cash flow system in addition to selling FOTM covered calls*) to cover the premium cost seems more realistic to me given the high risk in selling FOTM covered calls on a monthly basis.  Would you risk $220 to make $14? “

The first part of the question asked if it is realistic to sell covered calls to pay for a protective put. The simple answer is yes. If you buy a one-year put for $6 and you are willing to sell a series of OTM 30-day calls for 50 cents each, then assuming each call expires worthless, you will have received sufficient credit to pay for the put fully.

Before jumping into the thick of it, let’s take a step back.

A Put’s Purpose

If you believe IWM will rise over time, then why buy a put in the first place? There are two ways to control risk outside of stop losses: position sizing and purchasing puts. If through exploring the put route (with or without selling covered calls to pay for it) you discover it’s not worth the hassle and you’d rather ride the stock up and down over the long haul, then I’m okay with that. However, you better buy the right number of shares so you can stomach the occasional bear market (i.e., see the stock drop as much as 50%). In other words, don’t sock $25K in IWM if you’re not willing to see it drop $7,500 to $12,500 in a major bear market.

The reason for buying the put is to limit the max downside closer to 10% to 15% of your original investment. That should make it easier to hold IWM through bearish episodes. To summarize:

Choice #1: Buy a small enough number of shares of IWM so you can ride through bear markets.

Choice #2: Buy a larger amount of shares but use protective puts to limit your downside risk.

Now, let’s follow the second path. You buy 100 shares of IWM at $150.66 and purchase a Jan 2020 $136 protective put for $5.21. In doing so you’ve reduced your risk to $19.87 ($14.66 loss in stock + $5.21 cost of insurance), or 13.2% of your original investment.

In trying to decide if it’s worth buying the put here’s how I would think about it: am I willing to give up 3.5% of my upside profit (to pay for the put) in exchange for limiting my risk from 100% of the total investment to 13.2%? If the answer is “no,” then don’t buy the put or revert to Choice #1 above. Alternatively, I guess you could use a stop loss.

If the answer is “yes,” then buy the put and realize the 3.5% of upside profit you’re giving up this year is the price you pay for the peace of mind that you’ve dramatically reduced your exposure.

Financing the Insurance

Now, the next part of the question. Is it worth selling covered calls to pay for the put? Ryan’s point was that if he can receive the $5.21 paid for the insurance back through the selling of covered calls, then it cuts his risk down even more. I agree.

The drawback with adding the covered call component is you cap your profit potential in the stock. This is why in systems like the Bear Tamer we suggest you sell far OTM, such as a delta around 0.10 or 0.15.

Ryan understands all this. I can tell by reading his question. Here’s where I think I can add some clarity.

First, you have to decide how much you’re going to allow discretion to enter the equation with the selling of covered calls. Are you going to sell far OTM calls every month no matter what? Or, are you only going to sell calls when you aren’t aggressively bullish. I prefer the former approach. My forecasting skills are too unpredictable for me to alter when I do or don’t sell calls.

Second, you might be more worried about selling a call that ends up going ITM than you should be. The March $160 call has a delta of 0.06. To say you’re unwilling to sell anything with a lower strike means you’re unwilling to sell an 0.08 delta, 0.11 delta, and 0.15 delta (the $159, $158, and $157 strikes). That means you are extremely – extremely – bullish right now.

And that’s okay. if you have a good track record of predicting the 10% of the time that a 0.10 delta call ends up moving ITM then by all means, don’t sell calls this month.

Personally, I find it extremely difficult to do that consistently. For the 40 cents per month you need you’d be selling the $158 or $157 strike right here. I’d be willing to do it.

Third, you can’t look at the risk/reward of a short call in isolation when it’s part of a covered call position. This comment is extremely misleading- “However, based on the risk graph if the price hits $160, then I would incur a $220 maximum loss making the covered call a 1:11 reward: risk ratio.”

Remember, you own the stock. If IWM rises from $150.66 to $160 you will be up $934 on the shares. So even if you are down $220, your covered call position is still up a net of $714. That’s a good thing! Additionally, unless IWM climbs to $162.20, then the short $160 call will eventually be worth less than $220 as the time value decays away. So there’s a chance you could have profits closer to the entire $934.

The risk of selling far OTM calls against a stock is not that the stock will rise too much. Quite the contrary, that’s the BEST CASE SCENARIO! When I deploy this strategy, I pray for the stock to rise so much that I have to take losses on my short calls. SIGN ME UP!

Because of my disagreement on the lopsided risk/reward for short calls, I still believe they are an effective way of mitigating the cost of buying puts.

Thanks for the great question. If I omitted anything, set me straight in the comment section or clubhouse.