Learn How To "Protect" a stock, AND Simultaneously Generate Income

I love the versatility of options. 

Consider JAZZ Pharmaceuticals (JAZZ).  This stock has had an upward chart since its inception, currently trading at just under $155.00.  Some time ago, I sold a naked put on JAZZ at a $105 strike, expiry in 2016.  I collected a premium of $16.42, or $1,642.00 for each contract (recall that options trade in contracts, each contract controlling 100 shares, ergo, $16.42 x 100=$1,642.00).

Since that trade, the stock has rallied about $40 (or 40 points in the "lingo").  I'm beginning to wonder if it's going to pull back some, and I want to protect my profits from the sale of my put.

Recall that if you sell something, you take money in; while if you buy something, you pay money.  When you sell a put, you take premium money into your account; likewise, if you buy a put (or a call, for that matter), you pay money.  In this case, I sold a put, and received a premium of $1,642.00, as above.  That premium is now down to $868.00.  Since it is less than what I received into my account, it follows, then, that I would have less to pay in order to close this position.  In this case, to buy the put back to close, I would have to pay $868.00, but since I received $1,642.00, my profit would be $774.00, or 47.13% of my original premium.

But wait, there's more ...

As long as JAZZ remains so far above my sold strike price of $105, the likelihood of being "put" the underlying stock are relatively slim.  Therefore, I am inclined to keep my naked put and let it continue to "cook" until expiration.  This exposes me to some risk (that the stock will pull back dramatically, and I will be put the stock, in which case my basis would be $105-16.42=$88.58). 

So here's my dilemma, for lack of a better word: The stock is currently trading at about $155.  If I wish to "protect" that price of $155, I can do a couple of things: Buy a protective put at the $155 strike price, or sell a Bear Call Spread, or buy to close my naked put position.  Let's examine these possibilities (we've already discussed buying back the put to close the position).

If I buy a $150 strike put expiring in, say, January 2015, it would cost me $25.90, or $2,590.00 per contract (each contract controls 100 shares).  That's rather expensive.  But I can mitigate that cost! How? By selling monthly puts against it.

The next expiry is February 21, 2014.  The JAZZ $150 strike put currently sells for $4.30.  That means that my total outlay would be $2,160.00 ($2,590.00 - $430.00).  The caveat, of course, is that I have to be pretty comfortable that JAZZ would close above $150 by the February expiration, or it might be put to me at $150.  If it is put to me at $150, my basis would be $171.60 (because I paid $2,160.00 to own the protective put).  However, if the stock does decline and is put to me, I am not obligated to retain it - I exercise my $150 put.

If JAZZ remains above $150 by the February 2014 expiration, my premium of $430 will be mine to keep, and I can then sell the March expiration $150 put for more premium.  The idea here is to sell enough monthly premiums to pay off the cost of the protective put ($2,590.00), and hopefully make some income at the end of the line.

Let's look at a different scenario: With JAZZ currently selling at approximately $155 on the market, I could sell a January 2015 $150 put at $25.90 (for the sake of simplicity, I am not going to discuss bid and ask prices.  This is simply for illustration purposes).  Recall that when I sell something, in this case premium, I receive $25.90 or $2,590.00 into my account.  That's a very nice chunk of change, but also carries a risk, that the underlying stock pulls back below the strike of $150 and is thus put to me.  In that event, my cost basis in the stock would be $124.10.  I don't have to keep it - I could sell it back to the marketplace, or sell covered calls.

Let's see what happens if I sell an out-of-the-money $150 strike put expiring in January 2015.  I'm now on the line to be put a stock at $150.  I can mitigate that risk by buying the February 2014 $150 strike put at $430.  In this case, my premium credit would be reduced by the purchase of the put to $2,160.00, but I am also protecting myself against having the stock put to me.  I'm not as fond of this strategy. 

Covered Calls

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Selling covered calls is a way to enhance returns on stock you already own.  You are in effect using your stock as rental property, collecting monthly or semi-annual royalties on that stock.  In return, you are agreeing to part with that stock should it come up to a certain price level.  Selling covered calls generates income that also reduces your cost basis on the stock.  Let's say you have own Altria (MO) for years.  It has paid regular dividends, and periodically, you have purchased more shares.  You now have about 500 shares, and would be happy to generate more money out of that stock than mere dividends.  Why not collect some (rental) money while waiting for your money to grow or waiting for the dividends?  It is just sitting in a brokerage account; why not "use" it to enhance your returns.  MO closing price on April 21, 2011 was $26.06.  The December 2011 $27 strike calls are bidding $.75.  If you sell 5 contracts to cover your 500 shares, you will receive $.75 x 500=$375.00 into your account immediately.  The sale of a covered call means that should MO rise to $27.00 by the December expiration, you agree to part with your 500 shares at the strike price of $27.00. 

What could go wrong?  MO could crash.  In this example, you received $.75 per share for agreeing to sell your stock at $27.  That brings the break-even price down to $25.31 ($26.06 - $.75).  But if MO crashes down to, say, $20.00, clearly that $.75 does very little to mitigate that loss.  Then again, with or without selling the covered call, MO could still crash.

Covered calls are a terrific strategy to generate income from range-bound to slightly bullish stocks.

Covered Calls With a Twist

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First, a definition: Covered Calls are Call options sold on stock that one owns.  One does that in order to generate income.

Say you own some shares of QQQ (an ETF of Nasdaq 100 shares).  The closing price on April 21, 2011 was $58.34.  You need a minimum of 100 shares of stock in order to be able to sell covered calls on those shares, therefore, your out-of-pocket outlay to buy those shares is $5834.00.  Assuming you own at least 100 shares, and you wish to generate some income, rather than simply waiting for continued increase in the stock itself, you search the option tables and various expiration dates, and determine that you would be happy to part with your shares at $59.  The May 2011 $59 strike call options are trading at $.55 bid x $.57 ask.  If you sell 1 contract per 100 shares of the May 2011 $59 strike calls, you will receive $55.00 into your account.  By doing so, you have committed yourself to part with the underlying stock at $59 by Friday, May 20, 2011.  Since the stock is currently at $58.34, selling it at $59 means an additional amount of $.66, or $66.00.  Add that to the $55 premium received for selling the calls, and your total gain is $121.00.  If you bought the QQQ at $58.34 and sold those calls, your return would be 2.07% for less than 4 weeks.  That translates to a return of 26.96% per year. 

What's the twist? You can buy call options on the QQQ and sell call options against the ones you own.  Remember from prior entries that you can buy Call options with any expiration date, and at any strike price.  Let's assume you are long-term bullish on the direction of the Nasdaq, and are willing to buy the basket ETF, the QQQ.  You do not want to monitor your position every day, so you buy the 2013 expiration $60 strike price, currently listed as $5.32 bid x $5.49 ask.  You buy at the ask.  Ten contracts which control 1000 shares cost $5490.00, essentially the same as buying 100 shares of the ETF itself.  In order to create a spread, and thereby mitigating your cost, you now sell calls against this position.  If you decide to sell the May 2011 $60 strike calls, you will receive $220 ($.22 bid x $.23 ask).  Assuming the QQQ closes at less than $60 by May 20, 2011, your total cost for the position will be mitigated down to $5268.00.  You can then sell the June 2011 $60 strike calls (or any strike, or any expiration).  If the QQQ does rise above $60, your total cost of $5268 will be recovered, PLUS any amount up to $60, in this hypothetical case, $6000-$5268, for a very decent return.