Almost every day for the last several months I’ve been asked, “How do I protect my profits using options?” But the question has been rolling in far more frequently over the past few weeks, especially among those of you sitting on winning energy stocks. So, I’m going to go over my favorite strategy, step-by-step, for protecting profits without giving up potential future returns: a protective collar option strategy.
What is a Protective Collar Option Strategy?
One way to protect your profits is via an options strategy known as a collar. The strategy’s goal is to preserve 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, 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 surprise 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.
- 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.
I’m going to use just one of the many energy stocks that have made outsized gains in 2022.
How to Protect Profits in Exxon Mobil (XOM) Stock
Let’s say we own 100 shares of Exxon Mobil (XOM) and would like to protect our return going forward. We still want to hold the stock and participate in further upside. But we also realize that the stock has had an incredible run and want some downside protection, specifically over the short to intermediate term.
The stock is currently trading for 85.13.
- With XOM currently trading for 85.13, 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 June 17, 2022 options that are due to expire in 54 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 XOM 92.5 June call option with a delta of 0.26 fits the bill. We can sell the 92.5 call option in June for $1.65, or $165 per call. We can now use the $165 from the call sold to help finance the put contract needed to achieve our goal of protecting returns.
- 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.
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 July expiration cycle with 82 days left until expiration. I plan on buying the 77.5 puts for roughly $2.67, or $267 per put contract.
This means that a large portion of the total cost of the July 77.5 puts will be covered by selling the June 92.5 calls. And remember, we can sell even more for the July expiration if we wish to cover the entire amount and potentially receive an overall credit.
Total Cost: July 77.5 puts ($267) – July 92.5 calls ($165) = $102 debit
Again, we can actually add to our return by selling more calls in July while still maintaining our protection through July.
So, as it stands our upside return is limited to 92.5 over the next 54 days. If XOM pushes above 92.5 per share, at July expiration, our stock would be called away. Basically, you would lock in any capital gains up to the price of 92.5. With XOM currently trading for roughly 85, you would tack on an additional $7.50, or 8.8%, 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 XOM falls below 77.5 (where we purchased our put option). Essentially, you would only give up 8.8% of your overall returns and insure your position against a sharp pullback. The stock is up 40.7% year to date.
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? Tell us about your experience in the comments below.