Options afford traders the opportunity to achieve their objectives and/or trades in the market in ways that might not otherwise be available able to them, while limiting risks, particularly in volatile markets. Using options can also be a way to buy you time while you consider what you want to do with your stock position, as there may be dividend and capital gains tax considerations.
Today we’ll discuss a situation in which an investor wants to take profits at a price above the current market price. Investors have a number of alternatives when they are faced with taking profits, either by selling at market price and foregoing any upside, or alternatively they can try to capture a higher price while protecting their current position. Today we will illustrate the Protected Capped Covered Call Collar strategy. This protects your existing position while allowing you to participate in future upside movement in the stock.
The Protected Capped Covered Call Collar strategy is an options trading strategy traders can use to protect an existing position that has recently surged into a key resistance level. Rather than simply taking profits on the share position, paying capital gains tax and potentially missing out on future dividends and future upside, the trader enters into a Protected Capped Cover Call Collar. This strategy seeks to protect your existing share position while still participating in some of the upside, for a modest outlay.
If you are of the opinion that the stock market is due for a pullback and the share has little chance of breaking the key resistance level, or if you want to potentially sell at a higher price than the market offer, you could use a Protected Capped Covered Call Collar strategy. This strategy is similar to the protective put options strategy in that you also buy put options as protection. The difference is that you will now finance the purchase of those put options with the proceeds from writing an equal number of out of the money (OTM) call options.
The position will still protect you from losses below the strike price of the put options at minimal cost to yourself, but it will also stop the position from profiting beyond the strike price of the short call options should the stock stage another rally, and you could miss out on the dividend if this rally happens before the ex-dividend date. That is, you would miss out on a strong rally in exchange, but you get the protection of the put options for a minimal cost. Use the Protected Capped Covered Call Collar strategy when you expect the share price to move modestly higher or pull back significantly from current levels.
Protected Capped Covered Call Collar – is ideal for participating in future gains, while being protected on the downside.
Share Protection Case Study – Commonwealth Bank of Australia
Here at D2MX Advisory we recommended buying CommBank (CBA) for the dividend yield back in November last year, when CommBank was trading at $59.00. This trade was intended to capture the dividend(s), but the share price has subsequently jumped to as high as $73.60, where it looks like it may find near-term resistance. Recently we’ve had queries from clients wanting to know how they can take profits and or protect their position ahead of the next dividend which is not until next August.
So this week we discuss how you can potentially hold on to your CommBank shares, for the dividend, (CBA goes ex-div around $2.00 on 15 Aug 2013), while still having downside protection, by utilising the Protected Capped Cover Call Collar.
Given the recent surge in the banks and the old adage to “sell in May and go away”, we considered a Protected Capped Covered Call Collar was appropriate for protection for this position. It is difficult to define a profit target on this stock because it is trading at all-time highs, but based on technical analysis you can see from the chart below that Commbank has been in a steadily rising channel since last May and that the $75.00 resistance could be a key resistance level.
So at the start of the week, when CommBank was trading around $73.00, we priced protection at $72.00 by buying 7200 JUL13 Put for $1.65 and then selling the 7500 JUL13 Calls for $1.55. This trade cost 10 cents/share but we would be protected until the end of July expiry down to $71.90 and profits will be capped at $74.90. So the investor has 3% upside, while forgoing just over -1% downside**.
Chart 1: Commonwealth Bank (CBA) Protected Capped Covered Call Collar Trade
P&L Diagram at Expiry
Chart 2: Commonwealth Bank Protected Capped Covered Call Collar Trade P&L Diagram at Expiry
If CommBank (CBA) is still trading between the $72.00 and $75.00 option strike levels at expiry it will have cost 10 cents/share for the insurance of the share parcel. Ideally if CBA pulls back like it did this time last year, the position could be closed and the shares could be held for the run up into the dividend season.
For maximum profit we wanted CBA to pull back below the put strike price in the near-term, so the protected position can be closed and then for the stock to rebound for the dividend season.
Only time will tell where the share price will end up at expiry. However the position is protected until July expiry down to $71.90, but profits will be capped at $74.90**.
**Note: Transaction costs are not included.
Options can be used to reduce your risk while still participating in potential profits from moves in the underlying stock. The Protected Capped Covered Call Collar strategy, gives the investor flexibility, allowing them to participate is some of the future gains up to the sold strike price and potentially the dividend, while being protected by the put position.
Utilise the features in the d2mxIRESS software to trade plan your options trades for a particular options strategy using your specific trade selection criteria. You will save time and potentially reduce your trading risk.
For more trade ideas and recommendations on how to trade in this market, sign up for a free trial of the D2MX Daily Trading Report, which provides a daily serving of insightful market analysis and trade recommendations from the D2MX Advisory team, including:
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Investment Adviser – D2MX Advisory
Options Trading for All Types of Market Environments
Catch up with other articles in this series:
Part 1: The Protective Put
Part 2: The Covered Call
Part 3: The Covered Call Collar
Part 4: The Stock Repair Strategy
Part 5: Limited Risk Short Selling Strategy
Part 7: Dividend Capture Covered Call Collar
Part 8: Hedging With a Bear Put Spread
Part 9: The Bull Call Strategy
Part 10: Dividend Capture Covered Call Collar
Part 11: Calendar Call Strategy
Part 12: Bull Call Spread Strategy
Part 13: Reverse Calendar Call Strategy
Part 14: Short Selling Strategy with a Hedge
This report was prepared by Michael Hevern. It represents the views and opinions of the author. It is not intended for use by any third party, without the approval of Michael Hevern. While this report is based on information from sources which are considered reliable, its accuracy and completeness cannot be guaranteed. Any opinions expressed reflect my judgment at this date and are subject to change. Contracting Hevern Pty Ltd is a Corporate Authorised Representative No. 408868 of D2MX Pty Limited ABN 98 113 959 596, AFSL No. 297950 (D2MX), and Michael Hevern has been appointed as an Authorised Representative of Contracting Hevern Pty Ltd. Opinions, conclusions and other information expressed in this report are not given or endorsed by D2MX, unless otherwise indicated. The information contained in this Report is General Advice only, as the information or advice given does not take into account your particular objectives, financial situation or needs.
Disclaimer: Using leverage to invest can be a two edged sword, as it can magnify your returns when the stock price rises, but will in turn magnify the losses if the trade does not perform as expected.