SPY covered call with protective puts


Updated: Aug 3rd, 2011 | Vance Harwood

The biggest downside of covered calls is their lack of downside protection on the underlying.   A big, but not unusually big correction can wipe out many months worth of profits.   One strategy for reducing this exposure is to buy puts, but when I have looked into this strategy in the past the puts were either so expensive they ate up all the profits, or they were so far out of the money that they didn’t offer much protection.   I have found that the best way to really appreciate the strengths and weaknesses of a strategy is to have money at stake, so I started to look for a good situation to do some hedging on a covered call position.

Last Monday, August 9th I felt there was a higher than normal risk of a market pullback,  but there was still the opportunity for making some good profits on the weekly options. Some downside protection seemed like a good idea, and the OTM 111 puts were attractively priced at 0.35.    Late on the 9th  I bought  SPY at 113.01, sold-to-open 13-Aug 113 calls at 0.90, and bought  13-Aug 111 puts 0.35.   Maximum profit on this trade was 0.55 per share, and worst case loss was  1.46.   I had given up 39% of the profit to decrease the downside risk from essentially the entire value of the underlying to 1.46 per share.   Since there was only 4 days left on this trade the remaining  0.48% profit potential was still attractive.

The market dropped off sharply on the 10th.  In cases like this I will often buy back the calls.   If  I think the market is going to keep going down I’ll then sell ATM calls to harvest more premium, or if I think there will be a bounce back  I’ll wait to re-sell the calls, hoping to sell them again at a higher price than I just bought them back at.   In this case I bought back the 13-Aug 113 calls at .53, and later in the day resold them for .79 when the market did rebound a bit.

Wednesday the market really blew off.  I bought back my 13-Aug 113 calls at  0.12 and quickly sold 13-Aug 111 calls at 0.61 which I bought back later in day for 0.39.

Thursday I sold 13-Aug 110 calls at 0.22 and bought them back later at 0.13

Friday I closed out the position early because I was not going to be able to monitor the position the rest of the day, selling the SPY at 108.61 (down 4.40 per share)  and selling the 13-Aug 111 puts at 2.22 (up 1.87 per share)– I left about 0.2 on the table with the puts because I didn’t wait until near close to sell them.

In spite of all my call maneuvererings (which were all profitable)  I was still down 1.18 per share, compared to the worst case loss of 1.46 from just holding the position.   If I had not purchased  the puts I would have been down 3.5 per share,  almost triple the loss I ended up with.

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Wednesday, August 3rd, 2011 | Vance Harwood
  • Mike

    I disagree with your opening statement that covered calls suffer from a lack of downside protection. It all depends on what strike you choose. There are many attractive in-the-money covered calls that offer 20%+ downside protection.
    For example, right now you can buy GE at 15.45 and sell a Sep 12 call for 3.50. That's 23% downside protection. Factor in the dividend that goes ex-div Sep 16 and you have an annualized return if called (and if flat) of 15.5%. Not a world record setting rate of return, but for something that has 23% of protection not bad at all.
    MikeS
    http://www.borntosell.com
    covered call investment tools

  • Vance3h

    Hi Mike, Very good point. ITM calls can provide lots of downside protection. However I am wondering about your 15.5% yield calculation. If you get .05 premium on an net investment of $12 that is 0.4167% per month. If you do this 12 times a year that gives 5%. With GE's $0.12 quarterly dividend your options are almost certain to be called, so you won't get to add the dividend to your yield. What am I missing? You can probably get a couple more cents premium by beating the spread with a combo order, but that's still quite a ways from 15.5%.

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  • Vance3h

    thanks!