When market pullbacks come, I’m inundated with emails on how to protect profits. I get it, but the best time to “protect” your hard-earned profits is when the cost of protection or insurance is low. And that usually occurs when the market is rallying higher. But how can you tell if the cost of protection is high or low? The easiest way to find out is by quickly looking at at the volatility index, otherwise known as the VIX.
As you can see from the chart above, the VIX is nearing six-month lows which makes it a good time to start thinking about some potential protection, particularly in this widely vacillating market. Protective collars are a good way to do it.
The Protective Collar: The Basics
A protective collar’s goal is to preserve capital while simultaneously allowing a position to continue making profits, albeit limited.
Unfortunately, greed deters individual investors from using protective collars. Hedge funds and even large institutional managers frequently use collars, so why don’t most individual investors?
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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 for 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, 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 options strategy 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 what you do:
- 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 three 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.
The Trade – An Example Using the S&P 500 ETF (SPY)
Let’s say you own a basket of ETFs and want to protect your return going forward–or at least produce a bit of income from your positions while simultaneously hedging against a pullback.
Yes, you may have to forgo some upside profits in the process, that is if your position rockets higher, but you also have the reassurance that your profits are being protected over the short to intermediate term. And again, you are still able to make a decent profit if the ETF continues to trend higher.
Again, let’s say you own 100 shares of SPY and would like to protect your return going forward. You still want to hold the position and participate in further upside. But you also realize that the ETF has had an incredible run recently and want some downside protection, specifically over the short to intermediate term.
The ETF is currently trading for 412.11.
1. With SPY currently trading for 412.11, you want to sell an out-of-the-money call as your 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 23, 2022 options that are due to expire in 45 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. But, of course, ultimately the choice depends on your personal agenda.
As a result, let’s say I try to sell a call with a delta somewhere around 0.30. The SPY September 424 call option with a delta of 0.35 fits the bill. We can sell the SPY 424 call option in September for $6.15, or $615 per call. We can now use the $615 from the call sold to help finance the put contract needed to achieve our goal of protecting returns.
2. The second 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 going out as far as I can without paying too much for my protective put. In this case, I want to protect the position from a decline of 5% or greater. By taking this action, we would be protected below roughly $392.
I’m going to go out to the November 18, 2022 expiration cycle with 101 days left until expiration. I plan on buying the 390 puts for roughly $11.05, or $1,105 per put contract.
This means that 55.7% of the entire cost of the November 390 puts will be covered by selling the September 424 calls.
Total Cost: November 390 puts ($1,105) – September 424 calls ($615) = $490 debit
And we can actually decrease our debit of $490 by selling more calls in October and possibly November while still maintaining protection through November 18, 2022. The hope is that by selling more calls the cost of protection will be essentially free through November expiration.
So as it stands our upside return is limited to $424 over the next 45 days. If SPY pushes above 424 per share at September expiration, our ETF would be called away. Basically, you would lock in any capital gains up to the price of 424. With SPY currently trading for roughly 412, you would tack an additional $12, or 2.9%, to your overall return.
But the key reason to use the protective collar strategy is not about making additional returns, it’s about protecting profits. And through using a collar options strategy, in this instance you are protected if SPY falls roughly 5% lower or below 390 (where we purchased our put option).
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.
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