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First, let’s do a quick recap of the previous installment on covered calls, partially incorporating useful feedback
- By writing covered calls, you give up some of the upside, e.g. from 2% per month, in exchange for the income stream from option premia.
- By writing covered calls, you double dib in equity risk premia and volatility risk premia.
- The choice of 2% is not really random. Below 2% you give up too much upside. After 2% the option premiums are too low.
- The strategy will outperform simple “buy-and-hold” in bear markets, sideways markets, and when the market grows slowly. During strong bull markets, like we observe last decades (despite 3 major bear markets), it will underperform. If you believe that the bull market will generally continue then there is no need to bother.
- There are ETFs that implement the strategy. If you don’t mind paying, say, 0.6% to XYLD, then life is simple for you.
- Beware of taxes. Doing this outside of tax-free accounts may not be worth the effort.
Collar is a combination of selling an OTM call and buying an OTM put for protection. Typically, the investor selects the strikes to reflect his views and to make the trade approximately cost-free. For example, if I don't believe that SPY will grow above 630 (~10% up from now) until the end of 2026 and, at the same time, I am seriously concerned that the market can crash more than 10%, then I can (1) sell 610 call expiring in Jan-26 and (2) buy a 510 put expiring at the same time. Let's see how this looks on my trading screen:
Even if I accept the bid price 20.74 for the call and pay the ask price for the put 20.91, this transaction will cost be only $17 per contract. Usually you can get a better deal from your broker by specifying the limit price. What now?
If the price goes above 630, I'll give up all further gains as the call option holder will make me sell it for 630. If the price goes below 510, I'll sell my SPY to the put writer for 510, so I don't care how far the price drops below my put strike. If neither happens, then it's like buy-and-hold.
In other words, collar trade is a way to radically trim the tails of the probability distribution of future returns on your underlying investment.
Clear?
- By writing covered calls, you give up some of the upside, e.g. from 2% per month, in exchange for the income stream from option premia.
- By writing covered calls, you double dib in equity risk premia and volatility risk premia.
- The choice of 2% is not really random. Below 2% you give up too much upside. After 2% the option premiums are too low.
- The strategy will outperform simple “buy-and-hold” in bear markets, sideways markets, and when the market grows slowly. During strong bull markets, like we observe last decades (despite 3 major bear markets), it will underperform. If you believe that the bull market will generally continue then there is no need to bother.
- There are ETFs that implement the strategy. If you don’t mind paying, say, 0.6% to XYLD, then life is simple for you.
- Beware of taxes. Doing this outside of tax-free accounts may not be worth the effort.
Collar is a combination of selling an OTM call and buying an OTM put for protection. Typically, the investor selects the strikes to reflect his views and to make the trade approximately cost-free. For example, if I don't believe that SPY will grow above 630 (~10% up from now) until the end of 2026 and, at the same time, I am seriously concerned that the market can crash more than 10%, then I can (1) sell 610 call expiring in Jan-26 and (2) buy a 510 put expiring at the same time. Let's see how this looks on my trading screen:
Even if I accept the bid price 20.74 for the call and pay the ask price for the put 20.91, this transaction will cost be only $17 per contract. Usually you can get a better deal from your broker by specifying the limit price. What now?
If the price goes above 630, I'll give up all further gains as the call option holder will make me sell it for 630. If the price goes below 510, I'll sell my SPY to the put writer for 510, so I don't care how far the price drops below my put strike. If neither happens, then it's like buy-and-hold.
In other words, collar trade is a way to radically trim the tails of the probability distribution of future returns on your underlying investment.
Clear?
