Last update: August 2021
Earnings season is upon us. It’s a time where volatility returns to stocks across the land, and overnight gaps multiply. Holding your favorite stock into these quarterly events can be gut-wrenching, especially if you own hot momentum stocks with a history of monster moves (I’m looking at you AMD). I suppose if you’re swinging boring stocks that call the consumer staples, utilities, or finance sectors home then you have little to worry about. But for everyone else, well buckle up.
In the interest of buckling up, let’s talk about an ironclad way to protect your wares into uncertainty. Whether it’s a straight stock position, you’re holding for the long run, or one that you’re selling covered calls on there is a straightforward way to limit your risk.
It’s called a collar.
This gem of a strategy allows you to modify your position from unlimited risk and reward to a lower, defined risk and reward. For example, instead of riding AMD into earnings and risking a 20% loss for a potential upside windfall, I could use a collar to limit the outcomes to a 5% gain or a 5% loss.
Here’s how it works.
You sell a covered call and buy a protective put with the proceeds. Typically you use the same expiration on both options, and they both sit out-of-the-money at trade entry.
Imagine you own Twitter shares (100, to be exact) and have enjoyed the recent ascent from $15 to $24. As with all long stock holdings, you have unlimited potential for profit, but unlimited losses until the stock reaches zero. The risk graph is displayed below:
The blue bird has a long history of massive moves after earnings. And while the thought of an overnight double-digit percent gain is attractive, a plunge of equal magnitude could also strike. So why not collar this puppy ahead of its Feb 8th earnings release?
With the stock currently perched at $24.04 (I’m writing this article on Jan 18th), you could sell the Feb $26 call for 97 cents and buy the Feb $22 put for 75 cents. All told, you’re capturing a credit of 22 cents for placing the collar. Here are the essential formulas:
- Cost Basis/Breakeven: Purchase price of stock minus call premium plus put premium
- Max Reward: Call strike minus cost basis
- Max Risk: Cost basis minus put strike
Let’s use the current price of TWTR as our purchase price ($24.04). If we subtract the call premium (97 cents) and add the put premium (75 cents), we arrive at a cost basis of $23.82. That’s the price the stock would have to be at or above to at least break even.
By selling the $26 strike call, we’re obligated to sell the stock at $26. If we subtract our cost basis of $23.82, that means we have a potential profit of $2.18. That’s roughly a 9.1% gain.
By purchasing the $22 strike put we have the right to sell the stock at $22. If we subtract the put strike ($22) from the cost basis ($23.82), we discover the max loss is $1.82. That’s roughly a 7.6% loss.
Think about that for a moment. Instead of riding TWTR into the depths of uncertainty like a reckless cowboy, we’re taking a calculated risk in exchange for a defined reward. That’s a much more comfortable, if not wiser, approach.
The risk graph of the collared Twitter position is shown below:
If the premium received from the call is sufficient to pay for the put, then the collar is known as a no-cost collar. Keep this tactic in your back pocket for next time a quarterly report comes knocking.
Tackle Trading Resources on Covered Calls
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