Here at Profitable Investing Tips we routinely preach that long term investors should use intrinsic stock value as a guide to buying, holding, and selling when investing in stocks. However, there are more tools in a competent investor’s tool chest and one of these comes from the options trading arena. When the stock market and your portfolio have ridden higher and higher in a bull market, there typically comes a point at which the market turns around and goes lower. At these times stocks can be quite volatile and all of those years of stock price appreciation may be on the line. An options strategy for protecting investment gains at such times is a protective collar.
What Is a Protective Collar?
A protective collar, as one might guess, provides protection for stocks during a volatile market when the risk of a significant correction could mean the loss of years of stock price appreciation. The strategy involves buying a put and selling a call on the stock that you want to protect. The art of this approach lies in choosing the right strike prices and thus the optimal prices for the two options contracts in this strategy.
What Are Calls, Puts, and Strike Prices?
Options trading provides a trader with the opportunity to buy a contract that allows them to either buy or sell a stock at a set price no matter where the market takes the price during the term of that contract. A call is a contract to buy and a put is a contract to sell. The set price is called the strike price. The buyer of such a contract pays a premium for the opportunity and the seller receives the premium. While the buyer is under no obligation to buy or sell the seller of such a contract is obligated to fulfill the agreement should the buyer exercise their contract rights.
Protecting a Stock Position with Options
You invested in XYZ Corp. several years ago right after it went public. It has rewarded you by going up in multiples of its original value. And you believe it will very likely continue to grow and reward you over the years. However, the market is getting a bit stretched and you are afraid of stocks heading suddenly downward such as in the dot com crash, Financial Crisis, or the Covid Crash. A simple way to use options to protect a vulnerable stock position is to buy puts on that stock. One put contract covers one hundred shares of the stock. The price you will pay for this protection will depend on how much protection you want. The degree of protection depends on how far below the current stock price you choose the strike price for the puts that you buy. That is because the put contract will not give you the right to sell the stock until the stock falls to the strike price of the contract. Because the current market situation could last for months at a time you could be faced with repeatedly buying and paying for put contracts, which could become prohibitively expensive.
Mixing Calls and Puts to Protect a Stock Position
There is a way in options trading to protect a stock position with virtually no upfront cost. This is the protective collar when properly applied. In this approach you will buy puts to protect your position and, for the same stock with the same expiration date, you will sell calls. While you have to pay a premium for a put you are paid a premium for a call contract. The goal of this approach is to sell the puts and buy the calls at distances above and below the current market price so that you are not likely to have the stock called away from you by a normal market fluctuation and have a reasonable degree of protection against loss should the feared market correction take place.
Pros and Cons of a Protective Put Strategy
The upside to this approach is that you can provide a reasonable degree of protection against loss for a stock at a very low price. Thus you can keep repeating this strategy so long as the market remains risky. Meanwhile, you may end up selling a stock that has significant long term upside potential. This will happen if the bottom drops out of the market and you exercise your put contract and sell. You will not lose as much as someone who did not use this approach but you will lose the stock from your portfolio. However, you will be able to repurchase the stock at the market bottom and pocket the difference. You will also lose the stock if the price rises unexpectedly as the buyer of your covered call contract will exercise the contract. You will be paid a price higher than the current market price but will, nevertheless, be selling a stock that you believe has significant long term potential.
How Options Traders Handle Protective Collars
More often than not, options traders do not end up buying and selling stocks but rather exiting their contracts by executing the opposite trades when they want to take a profit or curtail their loss. When the bottom falls out of the market and your stock price falls significantly, the value of your put contract also goes up significantly. Rather than sell the stock you can exit that contract for a profit and use that money to purchase more of the same stock at market bottom or look for a new investment. That decision will typically depend on whether or not you still see the stock in question as a strong long-term investment.
Options Strategy for Protecting Investment Gains – SlideShare Version