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% in the first half of the year alone.
The charge higher continues to be led by seven stocks that made up over 50% of the weight of the ETF prior to a special rebalancing of the index at the end of July (the table below reflects the top 10 holdings as of July 20, prior to the rebalance).
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.
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 191.94.
1. With AAPL currently trading for 191.94, 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 September 15, 2023, expiration.
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 September 205 call fits the bill. We can sell the 205 call option in September for roughly $1.85, or $185 per call.
We can now use the $185 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 November 17, 2023, expiration cycle. I plan on buying the 165 puts for roughly $1.78, or $178 per put contract.
This means that the entire cost of the November 165 puts will be covered by selling the September 205 calls.
Total Cost: September 205 calls ($185) - November 165 puts ($178) = $7 credit
We can cover the entire cost of our November puts and actually add to our return (lower our cost basis even further), by selling more calls in October and even November while still maintaining the protective put.
- So, as it stands our upside return is limited to 205 until September 15. If AAPL pushes above 205 per share, at September expiration, our stock would be called away. Basically, you would lock in any capital gains up to the price of 205 and of course, keep our call premium of $1.85.
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 165 (where we purchased our put option). Essentially, you would only give up upside potential to insure your position against a sharp pullback. AAPL is up 53.5% 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.