Covered Writes for the Downside?

2013 has been a banner year for Covered Writes. The market is up big and this bullish strategy has been like an ATM machine. The S and P’s (S&P 500) have climbed from the 1400 level to its current peak around  1800 . That’s an increase of over 25%! What are your expectations for the rest of 2013?  How about 2014?  Maybe you are still bullish, but you would like to have a little less exposure on the downside in 2014? If you did 4 covered writes per month in 2013, maybe you’d like to cut back a bit and take a little capital off the table?

How can I diversify my covered write risk? One way is to have a few covered writes for the downside to diversify my exposure in my retirement portfolio. Most stocks are in the upper end of their 12-24 month price range. I will show you an example of a “covered write type” strategy for the downside that doesn’t involve stock. This will keep the cost and margin down significantly. Before I give an example for the downside, let me give an example of a covered write and Long Diagonal for the upside to lay the proper foundation. Using XYZ stock at $100 as our example, a covered write example would be to buy 100 shares of stock at $100 and sell one January 110 call at $1.00. This would be very expensive in an IRA account with your broker because of the cost of the stock. To do this strategy using an in-the-money call instead of the stock purchase would be called a Long Diagonal, and it would reduce the margin at your Broker significantly.

The Long Diagonal alternative might look like this:

Buy 1  March 85 Call and Sell the same January $110 call.

Because the cost of the long call would be much cheaper than the cost of the long stock, the margin on the Long Diagonal would be much cheaper than the Covered Write.And if the shares stay below $110 at January expiration, I could possibly sell February or March calls against the long March 85 call.  The graphs would look similar.

The example I will now  show , will be a Put Diagonal with a covered write type graph, but on the downside.

Put Diagonal example in AMZN: $390. Amazon started the year around $250 and is currently around $10 from the highs of the year. The stock is up around 55-60% for the year. Not all stocks are up this much for the year but many are up significantly. Even if you still like AMAZON , you might not expect similar returns next year, and might even think it could pull back a bit. A Put Diagonal would fit the bill if you think the shares might head lower in the next 4 months.   With the stock around 389-390 level, I might buy 1 April 440 put for $62 and sell 1 January 385 put for $13. The net debit for this put Diagonal would be $49. I have the right to sell AMZN at $440 until April, but have an obligation to buy the shares at $385 for the next 6 1/2 weeks.  The April 440 strike put at $62 is expensive, but with AMZN at $390 it is $50 in-the-money.   If I did this 1 time in my IRA account, it would cost about $4900, the cost of the debit. On the downside, at expiration, I could make from around $1000 at the short strike of $385, to around $600-$800 if we go down even near the $300 level. On the upside, we have an expiration Breakeven around $401, which I would use as a trigger to either take off or adjust. One adjustment idea if we are wrong, as we approach $400 level on the upside would be to roll the short 385 puts up near the 400 strike in the same expiration month.  This strategy also has an out-of-the-money option expire before the option owned.

Conclusion: These are timely strategies to discuss in this market environment because many people might want to lighten up a bit on their long exposure with covered writes and cash secured puts.  This is one way to do it.

Have a wonderful Day!  Give me a call, I would be happy to discuss your trading.   Dan Sheridan