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Protected covered write or collar

Protected covered write or collar

This strategy is use when share prices are expected slightly move higher, the protected covered write can be used to generate income, while eliminating the risk of a large potential loss on the stock. The investor would hold stock, write a call option with a higher strike and buy a put option with a lower strike.

In a worst case scenario the trader would lose the difference between the stock price at the time of entering the strategy and the strike of the call. This could happen if the stock falls to the level of the put. The loss is equal the to the difference between the stock price at the time of entering the strategy and the strike price of the put, less the net credit received from the options.

This strategy has the advantage of having minimal risk because the stock can always be sold for the strike price of the put.

There are some methods to prevent losses:

Strike price: when choosing which option to sell, the trader must balance the income to be earned against the level which they will sell their shares. Similarly when choosing which put option to buy, the investor must balance the cost of the put with the level of protection required.

The investor could sell an out of-the-money call and buy an out-of-the-money put, when there is an opportunity to sell shares for a profit and, remove much of the downside risk.

The protected buy and write/covered write is popular with investors buying stock on margin as much of the downside risk of owning the stock is eliminated through the purchase of the put. The strategy can be viewed as insuring the stock with a put financed either wholly or in part with the proceeds from the written call. Stock bought on margin through certain margin lenders can be lodged with ACH as collateral for the written calls on a one for one basis.

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