Options investing can be daunting to some investors. Admittedly, the endless array of strategies and risk can be overwhelming for the uninitiated, but options investing, like most things in life, are best when kept safe and simple and this is one of the safest option strategies available.
Which is why I want to introduce a tried-and-true options strategy for volatile times, much like what we have experienced throughout most of 2022.
As we all know stocks have been less than stellar this year with an endless drop that finally ended in June, a sharp rebound in July and a relatively flat August. That being said, the Dow, S&P 500 and Nasdaq are all lower by 11.7%, 14.7% and 23.1%, respectively in 2022.
Which leads me to one of the safest and easiest options strategies to implement right now … the protective collar.
Options Investing - The Protective Collar Option Strategy
Almost every day for the last several months, 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, so I’m going to go over my favorite options 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. So again, it doesn’t surprise me that the emails are piling in on how I protect profits.
Most investors simply buy puts to protect returns. But there is a far better alternative.
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, so why aren’t most individual investors using the safest 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. 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 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.
- 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 the heavily traded Apple (AAPL) 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 AAPL 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 as of late and want some downside protection, specifically over the short to intermediate term.
The stock is currently trading for 161.90.
- With AAPL currently trading for 161.90, 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 21, 2022, options that are due to expire in 39 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 AAPL October 165 call fits the bill. We can sell the 165 call option in October for roughly $4.40, or $440 per call. We can now use the $440 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 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 16, 2022, expiration cycle with 95 days left until expiration. I plan on buying the 150 puts for roughly $5.30, or $530 per put contract.
This means that almost the entire cost of the December 150 puts will be covered by selling the October 165 calls.
Total Cost: December 150 puts ($530) – October 165 calls ($440) = $90 debit
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 95 days.
- So, as it stands our upside return is limited to 165 over the next 39 days. If AAPL pushes above 165 per share, at October expiration, our stock would be called away. Basically, you would lock in any capital gains up to the price of 165.
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 AAPL falls below 150 (where we purchased our put option). Essentially, you would only give up 6% 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.