Almost every day for several months, I’m asked, “How do I protect my profits using options?” I generally favor a collar option strategy, and I’ve written about it to my subscribers before.
But the question has been rolling in far more frequently over the past few weeks, as many market participants are using the push higher as an opportunity to hedge their portfolios. So today I’m going to go over my favorite strategy, 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. How can you do it? Most investors simply buy puts to protect returns. Unfortunately, that’s one of the worst choices. There’s a much better approach…
The Protective Collar Option Strategy
A far better alternative and one that most professionals prefer is an options strategy known as a collar. The strategy’s goal is to preserve hard-earned capital, while simultaneously allowing a position to continue making profits, albeit limited.
Unfortunately, greed deters investors from using collars. Hedge funds and even large institutional managers frequently use collars, and the research backs them up, so why aren’t most individual investors?
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 on just in case the stock takes a fall. Think earnings surprises or if you own a stock that pays a healthy dividend that you want to keep holding. Or maybe investors don’t realize it is 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 to successful long-term 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 of it as a covered call coupled with a long put. Here’s how it works:
- Long Stock (at least 100 shares)
- Sell call option to finance the purchase of the protective put
- Buy put option to hedge downside risk
*Collar Option Strategy: long stock + out-of-the-money long put + out-of-the-money short call
That’s right, you read bullet point “3” correctly. 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.
Trying the Strategy on SPY
I’m going to use the heavily traded SPDR S&P 500 ETF (SPY) for my example.
Let’s say we own 100 shares of SPY 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 SPY has had an incredible run (historically) and want some downside protection, specifically over the short to intermediate-term.
The stock is currently trading for 394.04.
1. With SPY currently trading for 394.04, 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 August 19, 2022 options that are due to expire in 30 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.
As a result, I try to sell a call with a delta somewhere around 0.20 to 0.45. The SPY 405 August call option with a delta of 0.33 fits the bill. We can sell the 405 call option in August for $4.95, or $495 per call. We can now use the $495 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 in expiration? 60 days? 120 days? It really is up to you to decide.
I prefer to going out as far as I can without paying too much for my protective put.
I’m going to go out to the August expiration cycle with 30 days left until expiration. I plan on buying the 377 puts for roughly $4.66, or $466 per put contract.
This means that the entire cost of the August 377 puts will be covered by selling the August 405 calls.
Total Cost: August 377 puts ($466) – August 405 calls ($495) = $29 credit
- So, as it stands, our upside return is limited to 405 over the next 30 days. If SPY pushes above 405 per share, at August expiration, our stock would be called away. Basically, you would lock in any capital gains up to the price of 405. With SPY currently trading for roughly 394, you would tack an additional $11, or 2.8%, to your overall return.
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 SPY falls below 377 (where we purchased our put option). Essentially, you would only give up potential upside returns to insure your position against a sharp pullback.
Collars limit your risk at an incredibly low cost and allow 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 tool belt.
Have you used a collar option strategy before? If so, tell us how it went in the comments below.