A Collar On Steroids - The Covered Call Ratio Spread

 |  Includes: MDGL, TXI
by: William Campbell

A covered call is one of the most basic of all option trades, learned early by most. Inherent in the concept of the covered call is the downside protection, an amount equal to the stock price minus the call premium that defines the breakeven. Covered calls have many advantages, but the lament of the covered call writer is that the stocks he wishes to keep are called away, they appreciate in price, and he is stuck with ones he does not want to keep, those that do not go up. An alternative, roughly equivalent strategy, is the naked put sell. By selling puts the investor can control the entry point and buy the stock at a discount. But the put seller loses out on dividends and on any upside.

Buying puts against long positions is a protective strategy, effective but expensive. An investor with an established long term position in a blue chip stock may wish to protect against a decline. A long put will increase in value as the stock price declines, partially compensating for the loss in stock price. A collar, a.k.a. protected covered call, is a variation of the covered call, designed to give further downside protection, that involves buying a put at or near the breakeven of the covered call. The investor seeking to tweak his returns on a core holding might sell a call at a strike unlikely to be exercised and buy a protective put near breakeven or above his basis. Such a strategy is a plain vanilla collar.

For more risky but potentially more profitable stocks, such as small cap biotechs, one can screen for stocks that have a high ratio of call to put premium. Generally, look for an expensive call where the first OTM call premium is about twice that of the first OTM put. The idea is to sell an expensive call, accept the limited upside inherent in the covered call strategy, but protect against disaster. For example, consider Synta Pharmaceuticals (SNTA). With the stock at 6.69, the August 7.5 call premium was 6.7 % of the stock price. For comparison, the first OTM call premium for August for XOM was 1.1% and for a relative high flyer like FDO it was 3.5%. The first OTM SNTA put was 1.5% of the stock price, so the call had roughly 5 times the premium of the put. A collar selling the 7.5 call and buying the 5 put with the stock called away produces a profit of 18% in a little over a month.

Spreads are positions involving the simultaneous purchase and sale of options on the same underlying. There are many variations on the basic themes of bull v bear, call v put and debit v credit. A ratio spread exists when the number of options differs, mostly commonly 2:1. A covered call ratio spread (CCRS) resembles a collar, but instead of simply buying a long protective put, the position pays for the long put by selling as many further OTM puts as necessary to approximately fund the purchased put (a bear put ratio spread). A label may already exist in the universe of colorful option names, but I have not been able to find it.

The requisite caveat: never sell a put on a stock you do not wish to own. So identify a stock with similar call put premium attributes as for SNTA, but perhaps a better long term play. Consider the Texas Instruments (NYSE:TXI) October options. With the stock at 39.47, the October 40 call premium is 8% of the stock price, the 35 put is 4.9% of the stock price and the call is 1.6 times more expensive than the put, a favorable set up for a basic collar. The 30 puts are about half as expensive as the 35's, so selling 2 of the 30s should about pay for the 35 long.

So the trade would set up as: buy 100 shares of TXI at 39.47 and sell 1 Oct 40 call at 3.20 (all calculations use the worst case spread), the basis is now 36.27. Now buy 1 Oct 35 put and sell 2 Oct 30 puts, net cost for puts is 0.45. The basis is now 36.72. If called away at 40 the profit is 43%, annualized 152%. If the stock is unchanged at expiration, profit is 21%, annualized 75%. Rinse and repeat.

There are 3 approaches to take if the trade goes south. One is to let it play out, accept assignment of 200 more shares at 30, average down and sell more covered calls. Another is to bail out, cash in the profit from the long put and the short call, sell the stock and close the short puts while they remain OTM. All for a net loss, but less loss than just being long the stock. The best approach, assuming you still want to own the stock, is to sell the stock above the strike of the short puts, limiting the loss on the underlying, take the profits from the long put and short call and accept assignment at the short put strike, average down and go another round.

Disclosure: I am long SNTA.