Back at the start of May we advised our clients to protect their positions in the Yield trade, through a Protected Capped Covered Call Collar strategy which is an options trading strategy that can be used to protect an existing position that has recently surged into a key resistance level. 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.
Protected Capped Covered Call Collar – is ideal for participating in future gains, while being protected on the downside. 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.
It has been said by some analysts that the yield trade is dead, but this is only true until the prospective yield(s) get too enticing for the income investor to resist. The high-yield stocks have suffered heavily in the recent sell-off, triggered by the plunge in the Aussie dollar, after the RBA surprised with its May interest rate cut. These high-yield stocks are entering into a period of consolidation, but many analysts see a further sell-off in the near-term. With this in mind we thought it timely to revisit a collar strategy which our clients entered into back in May.
Today we’ll discuss how you would manage this trade, now that the high-yield stocks have had such a big sell-off. Investors have a number of alternatives when they are faced with taking profits, either by closing the collar and risk being exposed to more downside risk if the high-yield stocks sell-off further, or you could roll the position and lock in some profits.
The Initial Commonwealth Bank Trade, Early May
The trade we recommended back in May this year offered share protection over CommBank (CBA) shares. In this strategy we recommended protecting CBA shares that had run up from $59.00 in November last year, up to as high as $73.80, where we expected it to find resistance near-term. The trade was entered into to allow clients to hold CommBank shares for the dividend (CBA goes ex-div around $2.00 on 15 Aug’13) while still having downside protection, by utilising the Protected Capped Cover Call Collar.
It was 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 the stock has been in a steadily rising channel since last May and that $75.00 could be a key resistance level.
At the start of May, 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 of Australia (CBA) – Protected Capped Covered Call Collar Trade
**Note: Transaction costs are not included.
P&L Diagram at Expiry
Chart 2: Commonwealth Bank of Australia – Protected Capped Covered Call Collar Trade P&L Diagram at Expiry
For maximum profit we wanted CommBank to pull back below the put strike price in the near-term so the protected position could be closed, and then for the stock to rebound for the dividend season.
Managing The Trade
The old adage to “sell in May and go away” has proven a successful strategy once again this year, although it took until mid-May for it to transpire.
At the start of June CBA is trading around $66.25, so you have a number of alternatives.
Alternative 1 – Close off the Protected Capped Covered Call Collar
You could close the collar position for a credit of $5.70, see below. This would have compensated you for the $6.70 fall in the CBA share price and you still stand to pick up the next CBA dividend in August. However you are exposed to any further sell-off in CBA shares.
Table 1: Closure of the Protected Capped Covered Call Collar position giving a credit of $5.70
Chart 3: Closure of the Protected Capped Covered Call Collar – CBA Position is at Risk of Further Falls
Alternative 2 – Take Profits and Roll the Protective Put
You could close the SHORT 7500 JUL CALL for 10c debit and take some of the profits from the 7200 JUL PUT. If you rolled the 7200 JUL PUT down to the 6800 JUL PUT you could pocket $3.00 per share (or around half of the $6.70 fall in CBA shares price) and still have protection below $68.00.
Table 2: Take profits & roll the protective Put giving protection from a further CBA sell-off
Chart 3: Take Profits & Roll the Protective Put giving protection from a further CBA sell-off
Through this action you risk losing the value of the $68.00 PUT if CBA trades above this strike, however you do have more options if the CBA share price continues to weaken, including taking profits when you believe CBA has reached a bottom, or entering into a PUT spread to take some profits off the table.
Payoff Diagram at July’13 Expiry
Chart 4: CommBank Payoff diagram for the CBA JUL 6800 PUT (cost $2.70)
Only time will tell where the share price will end up at expiry. However the position is protected until July expiry below $65.30 (=STRIKE-PREMIUM PAID).
For maximum profit we want CommBank 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.
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 provides the investor flexibility, allowing them to either take profits now or alternatively take part profits now and roll the PUT protection, protecting the share position against any further precipitous fall in CBA while still potentially picking up the dividend.
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See Also: Options Trading for All Types of Market Environments
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
Part 15: Alternate Profit Taking Strategy
Part 16: Bullish on the Cheap
Part 17: Trade Smarter with Options
Part 18: Trade The Switch with Options
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.