The Hedge Wrapper Strategy

Now that we have looked at the covered call strategy, maybe you are thinking it still has too much risk for your taste. Well then the hedge wrapper or collar strategy should make you feel more comfortable. Most any stocks that would be a good candidate for an outright covered call strategy, would also be a good candidate for the hedge wrapper strategy. You will protect your downside risk, but also lower your rate of return.


Hedge Wrapper Introduction
One of the most common strategies is selling or writing OTM calls against a long position in underlying stock. This is also referred to as "covered calls" (CC). When utilizing this option strategy, the investor is neutral to slightly bullish about the direction the stock will move in the near term. CC writing is considered more conservative than strictly buying and holding stock because the risk is offset by the CC premium earned for selling the option or "call".
There is a buyer and seller using this option transaction: the owner of the underlying stock is considered the option seller or CC writer. As the CC writer, the investor is willing to limit the upside potential movement in the stock price by selling a call option with a strike price higher than (OTM) the stock price and immediately receiving the CC premium. The seller of the call is then obligated to sell the underlying stock (called out or exercised) should the stock price move higher than the call option strike price. But what if the stock price drops dramatically during the option period and the CC premium doesn't offset the loss in stock price? The CC writer could have large downside loss potential. That is where the Hedge Wrapper strategy, commonly known as a "Collar", comes into play. By purchasing protection on the downside with put options that are OTM (lower) in price than the stock price the investor gives up some of his/her CC premium, but lowers the investment risk by hedging and avoiding a major loss should the stock price drop significantly. Let's summarize the Hedge Wrapper strategy: 1) you will purchase the stock, 2) sell OTM call options which is a strike price higher than the stock price and 3) buy OTM put options at a strike price which is lower than the stock price. Thus, you have collared the stock price with call options above and put options below the stock price. Another characteristic of a Hedge Wrapper is the call and put options are sold and bought on the same underlying stock with the same expiration date.
It is important to note that no matter what happens to the stock price during the option period, the stock owner retains the CC premium (minus the cost of the put options). If the stock price stays the same through the option period, the stock owner retains the CC premium and the underlying stock and the call and put options expire worthless. If the stock price should move above the call option strike price, the stock owner still keeps the CC premium and may have the stock "called out or exercised" and the put options expire worthless. That's o.k. because the stock owner realizes profit from the CC premium and the increase in the stock price minus the cost of the put options. If the stock price should drop during the option period below the strike price of the put option, the investor retains the stock and CC premium and the investor has the right to "put" (sell) the stock at the put strike price. The only difference with a Hedge Wrapper play versus a straight CC write is you are limiting your downside risk by purchasing OTM put options. This will cost you a little of your CC premium, but it will save you large losses should the stock drop significantly. You can also still lose on the downside, however, if smaller drops in stock price occur: If the stock price drops below the price you bought the stock at, but is slightly above the strike price of the put, and the amount that you collected from selling the CC (minus the cost of the put options) doesn't cover the amount that the stock has dropped, then this could be a small loss. The Hedge Wrapper strategy is really designed to protect against catastrophic drops in stock price...it doesn't protect against small drops.
Call and Put Option Positions
There are a number of different terms that describe the option strike price in relation to the stock price. We will outline three terms, but keep in mind that the exact opposite is true for call options and put options. That is, a call option strike price that is higher than the stock price is considered an "out-of-the-money" position. If a put option has a strike price higher than the stock price, it is termed "in-the-money" and visa versa.
In-The-Money: This term refers to a call option strike price that is lower than the current stock price. For example, if a CC writer sold a call that is the May $10 strike price against a stock that is currently priced at $12.50, this would be considered an in-the-money call position. Again, the opposite is true for put options. If we buy the May $10 put option, it would be considered an out-of-the-money put position. This is the put position used when creating a Hedge Wrapper.At-The-Money: This describes a call option strike price and a stock price that are the same. For example, if the CC writer sold a call that is the May $10 strike price against a stock that is currently priced at $10, this would be considered an at-the-money call position. The same is true for put options, the same stock price and put option price equals an at-the-money put position.Out-Of-The-Money: This term refers to a call option strike price that is higher than the current stock price. For example, if a CC writer sold a call that is the May $15 strike price against a stock that is currently priced at $12.50, this would be considered an out-of-the-money call position. This is the call position used when creating a Hedge Wrapper. Again, the opposite is true for put options. If we sold the May $15 put option, it would be considered an in-the-money put position.
Let's refer to our call and put option descriptions. To create a Hedge Wrapper you would purchase the stock at $12.50, sell or write call options against the stock at the out-of-the-money (higher) strike price of $15 and buy the put options at the out-of-the-money (lower) strike price of $10.
Steps To Create a Hedge Wrapper
To write a Hedge Wrapper, you must first own the optionable stock. The investor can take either approach: Buy stock in 100 share blocks and simultaneously sell an equivalent number of call options against the underlying stock (what is known as a "buy/write") and then buy the equivalent number put option contracts. One call or put option contract is equivalent to 100 shares of stock. So, if you own 500 shares of a particular stock, you will sell or write 5 OTM (higher) call option contracts and buy 5 OTM (lower) put option contracts.
Here are some simple steps to create a Hedge Wrapper position:
Instruct your stock broker or enter your order through an on-line brokerage account and purchase the stock. You can then enter an option order to sell a specific number of call option contracts against your purchased shares and buy a specific number of put options equal to the number of call contracts sold. For example, you could purchase 500 shares and then turn around and sell 5 OTM call option contracts against those shares and buy 5 OTM put option contracts.
You must specify the month and strike price for the option contracts. Options are available in specific months and at specific strike prices. Here is an example of options available - $5.00, $7.50, $10.00, $12.50, $15.00, $17.50, $20.00, $22.50, $25.00, $30.00 and $5 increments thereafter.
Option Expiration Day - The Third Friday of each month is Expiration Day. When you sell the call options and buy the put options you have sold options that expire on the third Friday of a particular month. Both call and put option positions should have the same expiration date.
Hedge Wrapper Example
Let's go through a Hedge Wrapper example:
Stock Company Name/Ticker Symbol: ETrade (EGRP)Stock Price: $14.875Sold Out-Of-The-Money Call Option: 1 contract - June $15 @ $1.375Bought Out-Of-The-Money Put Option: 1 contract - June $12.5 @ $0.69Call Options Expiration Date: June (The market close of the third Friday of the month)
If we were to create a CC position (without downside put protection) we would purchase at least 100 shares x $14.875 = $1,487.50 and sell one OTM (higher) call option contract for an additional CC premium of $1.375 x 1 Call Option Contract (100 shares) = $137.50. In this scenario, the stock price would have to drop to $13.50 ($14.875 - $1.375) before our CC write would be at a break-even position.
If the stock price goes above the call option strike price, we retain the CC premium of $137.50 and also profit the difference between the CC strike price - stock purchase price or $12.50 ($15 - $14.875 x 100 shares). This would equal $137.50 + $12.50 = $150.00 or 10.1% return on a $1,487.50 investment in less than 30 days. If the stock price stays the same, we keep the $137.50 CC premium, retain the 100 shares of stock and can then write another CC on the same underlying stock after the June expiration date.
Now, let's include the purchased put option scenario to form a Hedge Wrapper. Let's make the assumption that we aren't quite sure the direction of the market or this stock price in particular. We would feel more comfortable if we had some downside protection should the stock fall below $12.50 (the put option strike price) and we are in a loss position. If we purchase the put option at $.069 x 1 Put Option Contract (100 shares) = $69.00, we have reduced our profit to $68.50 ($137.50 CC Premium - $69.00 Put Option Purchase) or 4.62%. Remember, our profit without the downside put protection is 10.1%. Therefore, the downside loss protection is costing us over half of our profit using the Hedge Wrapper strategy versus a straight CC strategy. Each investor must decide their risk versus reward criteria and fully understand the exact costs associated with their choice of option strategy.

Option Strategy: Hedge Wrapper (Own/Buy Stock, Sell Out-Of-The-Money Call Option , Buy Out-Of-The-Money Put Option)
Investor Sentiment: Neutral to Bullish
Profit Potential: Lower risk than strictly selling covered call options or buying stock outright, but limited profit potential. Realize revenue if stock price moves up, slightly down or stays the same. The positive side is the option seller realizes immediate profit from option premium from selling out-of-the-money (OTM) call options against underlying stock.
Drawbacks: Losing upside potential if stock moves up significantly. Also, buying OTM (lower) strike price put options costs the investor part of their CC premium in return for downside protection should the stock price drop significantly.


Now that you have a good understanding of all the tools for increasing your income by using a covered call strategy. Tomorrow we will start looking at individual stocks.