This bull market began in March 2009, more than eight years ago. At the time, investors feared the worst. But stocks rallied, proving once again that bull markets can climb a wall of worry. If all it takes for bull markets is a wall of worry, the current market environment would be healthy. But, a bull market also generally requires an economy that’s growing, an accommodative Federal Reserve policy and stable fiscal policy from Washington. The worries are that those three factors are not firmly in place and investors are right to be worried about a market environment as uncertainty rises.
As investors worry, they often consider the possible courses of action they can take. All too often, they limit their considerations to a binary decision tree. Many investors believe their only options are to hold stocks or reduce exposure to the stock market by raising cash. Of course, when they raise cash, they reduce their ability to benefit from any potential upside in the market. Investors raising cash may also expose them to large tax bills, a cost that might be avoidable for many investors.
Instead of selling a stock that shows a large gain, investors can use an options strategy to hedge against the downside risk of a large loss while allowing them to potentially participate in additional upside. This strategy is an example of how options can do more than many investors realize. In this and future articles, we will be addressing the potential uses of options, explaining how less well known strategies can help investors profit from any market environment.
This week, we are addressing a strategy known as a protective collar. This strategy can be used when an investor has a large gain in a stock and would like to obtain some degree of protection against a market decline. That is done by buying a put option. A put provides the buyer with the right, but not the obligation, to sell shares of a stock at a specified price for a specified period of time. A put buyer benefits from a market decline.
Both of the options will usually be out of the money which means they have no intrinsic value. The put will have an exercise price below the stock’s market price and the call will have an exercise price above the stock’s current market price.
But, while put options can act as insurance against a decline, they can be expensive to buy. The protective collar lowers the cost of the insurance by selling calls to generate income that can be used to pay at least part of the cost of the puts. In many cases, the protective collar can be “free” in the sense that the income from the call completely offsets the cost of the put. It is also possible the protective collar can generate income if the call brings in more income than the price of the put.
Before describing the benefits of the protective collar, it is important to point out that, as with all investment strategies, there is some risk involved. The risk in this case is that the call written to generate income is exercised and the stock is called away. This would result in selling the stock and generating the tax bill despite the efforts to avoid that situation. Despite the risk, the protective collar could still be useful.
For investors who are familiar with options, the protective collar can be thought of is as a covered call with a long put. Covered calls are call options written against stocks you own to generate income. If the stock price is above the call’s exercise price at expiration, the stock will be sold from your account and given to the investor who bought the call you sold.
A long put position increases in value as a stock declines. Rather than explaining this strategy in theoretical terms, we will use an example to demonstrate the protective collar.
Let’s use Amazon.com, Inc. (Nasdaq: AMZN) as an example. Twenty years after its initial public offering, shares of the internet retailer are up more than 63,000%. Assuming you bought the stock at its IPO, you would have a significant tax bill if you sold.
But, you also worry about losing too much wealth in a decline. With AMZN near $960, you decide you only want to risk about 10% of your capital. A 10% decline would push AMZN to about $864. To obtain this level of protection, you could buy a put option. There is a put expiring in October with an exercise price of $890 trading at about $28. This means if the stock price falls below $890, the value of the put will increase by $1 for every $1 decrease in the stock price. After paying $28, you will be fully protected against losses below $862. This option almost perfectly meets your goal, but it is expensive. With a protective collar, you offset the cost of the put by selling a call option.
You find an October call with an exercise price of $1,050 trading at $28 which exactly offsets the cost of the put. You sell that call and now have a cost-free downside hedge in place.
At expiration, one of three things will happen.
If there is a market selloff, let’s say AMZN falls to $800. You still own 100 shares of the stock which is now worth $80,000. The put option is worth $90 a share, adding $9,000 to your account value. The call option is worthless and the $2,800 you made by selling that option also adds to your account value. Your position is worth $91,800. Despite a 17% selloff, you lost just a little more than 4%. The protective collar provided significant protection.
If the stock is between $890 and $1,050, both options expire worthless. In this case you own the shares of AMZN and can now place another protective collar trade to preserve your profits.
If the stock closes above $1,050, the call will be exercised. In this case, you sell the shares for $1,050 earning $105,000. Your gain will be fully taxable since the options offset each other. But, this is the worst case of the protective collar. When the worst case of a strategy involves booking a large profit, the trading strategy does appear to have some use.
To limit the risk of exercise on the call, an investor could sell a call that is further away from the market price. For example, a $1,250 call on AMZN could be sold for about $3.50. This would only offset part of the cost of insurance but has less risk of exercise. Individuals would need to balance the cost of insurance with the risk of exercise to determine the right options for their personal risk profile.
The protective collar should not be used in a strong bull market. But, it can be useful in a bear market or a sideways market. At times like this, when the bull market is rather old and possibly near its end, the strategy could make sense.
There are many other option strategies besides the familiar buying or selling of puts and calls. In fact, options trading strategies can help investors accomplish almost any objective in the stock market trading. In the coming weeks, we will be exploring many of these strategies and explaining how individuals can benefit from the ideas professional investors have used for decades to protect and increase their wealth.