The most obvious method to evaluate investment progress is to track your account value over time.  If the account value is rising, then you’re making money.  If the account value is heading lower, then you’re losing money.  This seems pretty straight forward, but it’s not always that simple.  Sometimes it depends on what points in time you choose to track.  Does it make sense to track daily, weekly, or maybe monthly?  The answer depends on the strategy you’re using to invest. 

More complex strategies require additional thought to evaluate.  This is the case for our Collared Income strategy.

I’ll begin by stating clearly for the record:  The current value of your account that you see online is correct.  This is the best estimate available for what you would have if you were to sell everything immediately and take your account to cash.  Of course, we have no plans to do so.  This is where the evaluation of Collared Income becomes more complicated.  To better explain, here’s an example.  Let’s say we’re baking a cake.  We begin the process by putting the ingredients together.  We mix the eggs into the batter along with the vegetable oil.  Then we carefully pour the batter into the mold.  We place the batter-filled mold into a pre-heated oven.  Set the timer to 60 minutes.  And now we wait.  Would it make sense to take the cake out of the oven in 5 minutes, declare the cake is done, and judge whether we have an award winning recipe?  Of course not.  It hasn’t finished cooking.  We haven’t even iced it yet.  Some investment strategies work in the same way.  They have to “cook” first.  This is definitely the case with Collared Income.

Our Collared Income strategy is one that “needs to cook”.  First, we buy dividend-producing stocks just before they go ex-dividend.  Once we buy the stocks we immediately sell “covered calls” to generate income.  We use this income to purchase “protective puts” to protect our downside.  The use of covered calls and protective puts together is known as a “collar”.  Now it’s ready to go into the oven.  We actively manage these “collars” with the goal of creating a positive, net gain for each stock.  The investment is “cooking”.  When a positive, net gain is achieved, we sell the stock.  This is like “icing the cake”.  Now it’s done and ready to go.  We’ve realized a profit and we can start the whole process over again.  The goal of this strategy is to receive as many dividend payouts as possible using the same money while maintaining constant downside protection.

Any down movement in your account value is expected to be only temporary and part of a management plan instead of an actual problematic situation.  In turn, a proper performance evaluation must include more than just the current account value while the investment is “cooking”.  This is clearly an unwanted complication, but I believe the end result is well worth it.  Our Collared Income strategy has the best risk vs. reward characteristics I’ve ever seen in near 20 years that I’ve been in this business.  Building upon this point, I run my practice as a fee-only, investment advisor.  I do not sell products for a financial services firm to earn sales commissions.  Unhindered, I have the freedom to utilize whatever investment strategy gives my clients the best opportunity to maximize potential while greatly limiting risk.  I understand that Collared Income is not a strategy for everyone because it is complicated with lots of moving parts.  It is a cutting edge, professional style of investing.  My experience tells me that even though it is complicated, my clients are intelligent.  We’ll work through the learning curve together and be much better off as a result.  Complication is not a good excuse to constrain our investment potential.  Actually, once one understands the “rules of the game” and a “lightbulb goes off”, Collared Income is really not that difficult to understand and follow.

There are 7 different reasons I can think of that would cause your account value to drop temporarily.

  1. It is necessary to allow for the possibility of a relatively small, temporary, unrealized loss. I refer to this as the “managed range”.  This is the difference in the current price of the stock and the protective put’s strike price at the time it is purchased.  This difference occurs because of the way in which puts are priced by the market.  The higher the strike price, the more expensive the put.  Ideally, we want to spend the least amount of money as possible to buy the put.  This helps to lower our breakeven point faster.  On the other hand, the less money we spend on the put, the larger the “managed range”.  If the stock were to fall in value, then we’d take on a larger unrealized loss pulling our account value lower in the short term.  If this happens, we still have put protection – just at lower price point.  If instead the stock price moves higher, we’ll be able to turn it net positive sooner.

We know that stocks go up and down all the time.  It is expected.  Collared Income works because of these expected price movements.  If a stock moves lower it’s not necessarily a bad thing for us.  Our put protection literally caps our downside risk at its strike price.  Also we’ll use the covered call side of the equation to lower our breakeven points.  Whenever one of our stocks drop in value, then we can buy back the call we’ve already sold for less than we were originally paid – sell high, buy low.  From there, we can sell yet another call on the same stock to generate even more cash.  This is a great methodology to create a positive cash flow and lower our breakeven points.  Again, this is all managed and strategically planned for ahead of time.

I’m not as concerned about maintaining our short term account value as I might be if we were using a traditional style of investing – because I don’t have to.  Instead, I’m much more focused on actively managing the collars and breakeven points.  We want to have the best potential to reach a net positive position quickly.  Sometimes this will necessitate a temporarily lower account value limited to a “managed range”.  Our biggest concern should be our profitability over a longer time period.  In turn, our Collared Income strategy is what might be termed as an “intermediate plus” style of investing.

 

  1. If the general direction of the stock market is downward, I expect the “managed range” to be a bit wider than it normally would be. This is caused by the variance in prices of the calls and puts.  (If the consensus is calling for a down market, puts are more expensive.  If the consensus is instead calling for a rising market, puts are less expensive and we’re paid more for the calls we sell.)  The widening of the “managed range” does not necessarily result in a lower account value.  The account value will be lower if the stock prices drop down to or below the floor set by the put strike price.  Another point here is that our breakeven point could potentially move higher if we pay more for the put than we’re paid for selling the call.  If so, this too would cause our account value to be lower.
  1. The current value of any outstanding, covered calls are subtracted from the overall account value.  This occurs because it would be necessary to buy back the covered calls at the going rate to immediately take your account to money market.  Of course, every time we sell covered calls, this issue lowers the account value.
  1. Option pricing is based upon two main components: time value and intrinsic value. The best way I can explain how these components work is with an example.  Let’s say we buy a stock at $100 per share.  Let’s sell a call with one month until expiration with a strike price of 102.  We’re then paid $300 per call we sell.  (These calls would be quoted as just $3.00 because each one equates to 100 shares of stock.)  At this point, the call price is $3.00.  Time value = $3, Intrinsic value = 0.  From there, the price of the underlying stock rises to 110, one week after we sold the calls.  Now the price of the calls have gone up to $10.00.  Time value = $2.00, Intrinsic value = $8.00.  At the time of expiration, the stock price is still 110.  The option will be worth $8.00.  Time value = 0, Intrinsic value = $8.00.  Time value erodes and will be worthless at expiration.  The only value left in the option will be the intrinsic value.  If instead the price of the stock was 102 or less at expiration, then the option would have no value.  Time value = 0, Intrinsic value = 0.  If you can understand this example then you’ve got it.

Puts work the same way, but in the opposite direction.  Also, one has to remember that we’re selling calls and buying puts.  Not only are we on the other side of the equation by buying puts instead of selling them, put prices also move in the opposite direction from calls.  Needless to say this is complicated to explain even by my standards.  Here’s the short version from this point:  It is possible that the time value/intrinsic value mechanism of put pricing will cause the account values to drop temporarily until our puts reach expiration and achieve their full intrinsic value.

 

  1. Sometimes option pricing isn’t as efficient as I would like. Scottrade prices options on your website or statement based upon the last one traded.  Many times the last trade does not equate to what actual option price would be to buy or sell right now.  Instead, the last trade could be “old news”.  For example, if a stock price is gapping downward, the last option traded may not reflect this change in stock price.  This has happened recently with the large amount of market volatility, and may result in a temporarily lower account value.
  1. Depending on the situation, I don’t always sell covered calls.  Sometimes we’ll want to buy them back and take a profit on them early before they expire.  Recently, I was able to buy back our covered calls early when the market was way down.  I purposely did not sell new calls to generate income because I was concerned that the market would experience a sharp bounce higher.  As it turned out, that’s exactly what happened.  It was good that I didn’t sell more calls because I would have had to sell them using a strike price that would have turned out to be too low.  Although this was the right thing to do, it caused our breakeven points to be a bit higher than they would have been otherwise – in turn your account value was temporarily lower.
  1. If I buy puts with a longer expiration than the calls we sell, it is likely that I will have temporarily spent more money to buy the puts than I have been able to generate by selling calls. This is done purposely.  For example, if a 1 week put costs us $1.00.  The 2 week put might cost only $1.75.  The 2 week put is actually cheaper from if we divide the cost by 2.  The weekly cost would only be .875.  Once again, this would temporarily result in a lower account value.

In the short term, the account value is still “cooking” so it won’t tell us that much.  The best method I’ve found to monitor the short term profitability of our Collared Income system is to simply keep track of the dividends we’ve been able to produce.  Also, we can easily track the collars themselves.  We can look at the collars to be sure we are able to lower our breakeven points with some consistency.  We’ll also focus on the relative size of the collars, i.e. the dollar amount of the distance from the ceiling to the floor.  Another variable to watch is the distance between the current price of the stock and the breakeven point.  I already have created and consistently maintain spreadsheets to report on this information.  I’m happy to email the report to you whenever I have an update.  Of course, I’m always available to discuss the report in detail.

Collared Income was designed specifically to create a profitable opportunity with every stock we purchase.  In turn, we’re really not worried about unrealized losses in the stocks we own.  If we have unrealized losses, the investment is still “cooking”.  We aren’t worried because we’re actively managing the collars to create profitability.  The collars act something like a trap in which we “catch” the stocks and force profitability.  We believe it is “just a matter of time”.

Time is an important variable in Collared Income.  We don’t know how long it’ll take to turn each investment positive.  Sometimes it’ll be a week or less, other times it’ll be much longer than that.  Much will depend on the stocks’ price movements which we have no control over – which is why we need the collars in the first place.  I do believe that the worst case scenario would be to only sell our stock at a net gain after a longer period than we’d like.  If this turns out to be the case, we’re still not losing.  The account value would rise up above where we started and then we could repeat the process.  Hopefully, taking much less time to turn our stocks net positive the next time around.

Our Collared Income strategy is designed to do much more than just limit risk.  It creates the potential for sizable, double-digit, annual returns.  Of course, I cannot guarantee returns.  But it is not difficult to see how this strategy could reach a big potential.  Lots of small gains will add up quickly, and will hopefully equate to a big gain.  Again, the ultimate performance will be based on how quickly we can turn each stock position to a net positive and enter into others as they go ex-dividend.  And repeat…