Almost every other day for the past month, I’m asked, “How do I protect my profits using options?”
But the question has been rolling in far more frequently over the past few days, as more and more “bearish” news creeps into the market, valid or not, so I’m going to go over one of my favorite options strategies, step by step, for protecting profits without giving up potential future returns.
I mean, it’s no surprise to me that protecting profits is a major concern for intelligent investors right now. Look no further than the chart below to see that we’ve seen one the best starts for the tech-heavy Nasdaq 100 ETF (QQQ) over the past twenty years.
And unless you think the Nasdaq 100 is going to continue this trajectory for the next few months, taking the time to implement a strategy that not only protects your profits but allows you to continue to benefit from future upside, albeit limited, might be the prudent move.
The strategy I want to discuss today is known as a collar. Again, the strategy’s goal is to preserve hard-earned capital, while simultaneously allowing a position to continue making profits.
Unfortunately, greed often deters individual investors from using collars. Hedge funds and even, large institutional managers frequently use collars, so why aren’t most individual investors using this safe, protective options strategy?
It’s because most investors don’t realize that collars not only protect their unrealized profits, they also allow you to hold a position that you don’t want to sell but want some downside protection just in case the stock takes a fall. Think earnings surprise or if you own a stock that pays a healthy dividend that you want to keep holding through what you feel is a correction phase for the market. Or maybe investors simply don’t realize they are one of the cheapest, yet most effective ways to reduce risk.
It doesn’t really matter the reason; it only matters that you start using this strategy to keep risk in hand. Because the most important aspect of successful, long-term options investing is a disciplined approach to risk management. Without it, even the best strategies are inevitably doomed.
A collar is an options strategy that requires an investor, who already owns at least 100 shares of a stock, to purchase an out-of-the-money put option and sell an out-of-the-money call option.
Think about it as a covered call coupled with a long put.
1. Long Stock (at least 100 shares).
2. Sell call option to finance the purchase of the protective put.
3. Buy put option to hedge downside risk.
Collar Option Strategy = long stock + out-of-the-money long put + out-of-the-money short call
You can actually finance most of your protection, so the cost of a collar is limited, if not free. Again, this is why intelligent investors and professional traders use collars habitually.
I’m going to use the heavily traded Nasdaq 100 ETF (QQQ) for my example, but you can apply this technique to any stock or ETF in your portfolio.
Let’s say we own 100 shares of QQQ and would like to protect our return going forward. We still want to hold the ETF and participate in further upside. But we also realize that the ETF has had an incredible run in 2023 and want some downside protection, specifically over the short to intermediate term.
The ETF is currently trading for 364.91.
1. With QQQ currently trading for 364.91, we want to sell an out-of-the-money call as our first step in using a collar option strategy.
- I typically look for a call that has roughly 30-60 days left until expiration. So, to keep things simple, I am going with the October 20, 2023, options that are due to expire in 58 days.
I don’t want to sell calls that are too far out of the money because I want to bring in a decent amount of premium to cover most, if not all, of the protective put I’m going to buy.
The QQQ October 20, 2023, 385 call (highlighted in blue below) fits the bill. We can sell the 385 call option in October for roughly $4.04, or $404 per call. We can now use the $404 from the call sold to help finance the put contract needed to achieve our goal of protecting returns.
2. The next and final step is to find an appropriate protective put to purchase. There are many different ways to approach this step, mostly centered around which expiration cycle to use. Should we go out 30 days to expiration? 60 days? 120 days? It really is up to you to decide.
I prefer going out as far as I can without paying too much for my protective put.
I’m going to go out to the December 15, 2023, expiration cycle with 114 days left until expiration. I plan on buying the 350 puts for roughly $9.91, or $991 per put contract. This covers any losses below 350 or, 4.2% lower than where QQQ is currently trading.
*If you wanted to lower the cost of your puts you could simply buy a put at a lower strike. You would give up some downside protection by doing so, but the cost of the protective put would be less.
This means that almost half of the entire cost of the December 350 puts will be covered by selling the October 385 calls….and we can sell additional calls after our October 385 expires to cover the rest of the cost of our December 350 puts.
Total Cost: December 350 puts ($991) – October 385 calls ($404) = $587 debit
Again, we can cover the entire cost of our December puts and actually add to our return, by selling more calls in November and December while still maintaining protection over the next 114 days.
- So, as it stands, our upside return is now limited to 385 over the next 58 days. If QQQ pushes above 385 per share, at October expiration, our stock would be called away. Basically, you would lock in any capital gains up to the price of 385.
But the key reason to use the strategy is not about making additional returns, it’s about protecting profits. And through using a collar option strategy, in this instance, you are protected if QQQ falls below 350 (where we purchased our put option). Essentially, you would only give up 4.2% of your overall returns and insure your position against a sharp pullback.
Options investing using collars limits your risk at an incredibly low cost and allows you to participate in further, albeit limited, upside profit potential. I’m certain you won’t regret adding this easy, yet effective options strategy to your investment toolbelt.