Cabot Options Institute Chief Analyst Andy Crowder will be hosting a live webinar, A 15% Income Trade You Can Make Before Independence Day on Thursday, June 29, at 2:00 PM ET. To learn more and to register to attend live or receive the webinar recording immediately after the event ends, simply click here.
After a tumultuous 2022, the tech-heavy Nasdaq 100 (QQQ) turned about-face in 2023, at least so far. In fact, we are witnessing the fastest start for the “triple-Qs” over the last two decades with a return just under 40%...and we haven’t reached Independence Day.
And as every market pundit has stated over and over this year, the charge higher continues to be led by seven stocks that make up over 50% of the 100 stocks that reside in the ETF.
So, the question is, do you protect your hard-earned profits, giving them a little more upside wiggle room or simply allow them to continue to hopefully run higher?
Almost every day for the last several months, I’m asked, “How do I protect my profits using options?”
The question has been rolling in far more frequently over the past few weeks, 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, or many other market professionals, that protecting profits is a major concern for some investors right now. So again, it doesn’t surprise me that the emails are piling in asking how I, as an options trader, protect profits.
Most investors simply buy puts to protect returns. And that’s a valid choice. Options are cheap right now as my colleague Jacob Mintz recently pointed out. He stated “…and the good news for put buyers is the VIX, which is a measure of fear in the market and affects the price of options, is at a multi-year low. Essentially insurance against a market decline is very cheap historically”.
But that’s what’s great about options, there are always alternatives.
An alternative that many professionals use, particularly those that prefer to sell options, is an options strategy known as a collar. With a collar you can essentially finance, most, if not all, of your protection over a specific duration. A collar option trade is less bearish than buying puts outright, but it still protects a position from taking large losses. And again, selling the upside call helps finance the protective position.
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 investing is a disciplined approach to risk management.
“Now Ever Since I Can Remember I’ve Been Poppin’ My Collar”
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
That’s right, you read bullet point “2” 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.
At the time of writing, the stock is trading for 186.90.
1. With AAPL currently trading for 186.90, 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 August 18, 2023, 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.
The AAPL August 200 call fits the bill. We can sell the 200 call option in August for roughly $1.68, or $168 per call.
We can now use the $168 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 October 20, 2023, expiration cycle with 117 days left until expiration. I plan on buying the 160 puts for roughly $1.78, or $178 per put contract.
This means that almost the entire cost of the October 160 puts will be covered by selling the August 200 calls.
Total Cost: October 160 puts ($178) – August 200 calls ($168) = $10 debit
We can cover the entire cost of our October puts and actually add to our return (lower our cost basis even further), by selling more calls in September and even October while still maintaining protection over the next 117 days.
- So, as it stands our upside return is limited to 200 over the next 54 days. If AAPL pushes above 200 per share, at August expiration, our stock would be called away. Basically, you would lock in any capital gains up to the price of 200 and of course, keep our call premium of $1.68.
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 160 (where we purchased our put option). Essentially, you would only give up roughly 13% of your overall returns and insure your position against a sharp pullback. AAPL is up 44.1% year-to-date.
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.