The major stock indexes are acting toppy and economic fear reigns supreme around the globe. Most investors are very confused about whether or not to take profits or to hold on for greater gains.
There are strong signals that the bull market is coming to an end. Even many professional traders are confused about what to expect next.
The index of fear known as the VIX has spiked to near 20 within the last seven trading days. Also, the VIX has moved above its 200 week simple moving average for the first time since the start of the year.
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A combination of climbing interest rate fears and international tensions have resulted in rising volatility in the stock market. As you know, high volatility is often associated with market tops.
The latest market rocking event happened mid-week with a technical glitch knocking out the New York Stock Exchange for some hours.
However, at the same time, the economic picture in the United States is steadily improving. While this improvement creates a “catch-22” situation of triggering higher interest rates that in turn may quickly suppress the bull market, it remains the best thing to happen for the long run.
In the face of this confusion, stocks seem to keep pushing higher. This phenomenon is called “climbing the wall of worry.” Stocks often move higher despite tremendous bearish economic pressures. That is until they stop, and prices plunge.
The Good News
Fortunately, most investors are sitting on substantial profits as a result of the runaway bull market. Many are asking whether or not it’s time to take the profits or just keep holding to capture future gains.
The truth is no one knows what the future will bring in the stock market. While all signals are that the Bull Run is quickly ending, stocks have a way of making fools of even the most learned analysts.
The good news is that you don’t have to sell your stocks to protect your profits just in case the bottom falls out in the stock market.
There is a tactic that can allow you to hold your winning stocks to capture additional upside potential and protect the downside at the same time.
This method is particularly appealing if your stocks are dividend producers that you don’t want to sell but are afraid are heading lower.
The strategy is known as an Option Collar.
Collars are an easy to use option strategy. A collar is used by investors who seek to limit the downside risk of a winning stock position at little or no cost. In fact, some collars can be designed to earn a profit just for using one. Sound amazing? You bet it does!
What Is A Collar?
A collar is the concurrent purchase of a put option and the selling of a call option.
Each options is out of the money and usually have the identical expiration date.
For every 100 shares of stocks whose profits need protected from, one put is bought, and one call is sold at the same time.
For example, if you own 500 shares of XYZ, a collar would consist of buying ten put options and selling five call options to protect all 500 shares. The options are purchased out in the month representing the amount of time you are seeking downside protection.
For example if you think your stock will stabilize in 3 months, the options chosen for the collar would be 3 or more months until expiration.
The collar strategy is ideal for investors seeking a risk adverse approach providing a realistic rate of return with managed risk.
The secret to being successful with collars is choosing the appropriate put and call mixture that allows gains while mitigating the downside risk.
The neat thing is that you can roll the puts and calls from month to month creating a stable 3-5% monthly return is the stock behaves as expected.
Rolling means to repurchase short calls and write fresh calls for another month and sometimes different strike price, and buy new puts for that month.
In other words, adjusting the collar to fit the price of the stock in that particular month. This is a very popular strategy among professional option traders. Many earn their living doing this consistently.
Believe it or not, corporate executives often use this strategy to protect their capital if it is concentrated in the company’s stock. The collar protects the executive’s wealth without forcing the expense of costly put only protection.
I thought options were expensive insurance, why is this cheap or even free?
The reason collars are cheap or even free downside insurance is simple to understand.
The premium obtained from the call options is what is used to pay for the purchase price of the protective put options. If you can establish the collar at no cost since the premium earned is greater than the cost of the purchased option, the collar is known as a zero-cost collar.
You own 1000 shares of XYZ stock that is now trading at $35. A bearish word from the company has knocked the stock off its highs of $37, and you become concerned it could easily go lower over the next several months.
You want to keep holding the stock, so the decision is made to use an option collar for downside protection.
The way it works is you buy ten put options five months from expiration at the $32 strike price for $2 per option ($200) or $2000 total.
Simultaneously, you sell ten call options, five months from expiration with a $38 strike price at $2 per option ($200) or $2000 total. Thereby creating a five month zero cost collar to protect your stock investment from downside.
The good news about zero cost collars is that they allow for some upside potential in the stock.
The collar strategy can also be designed to create income. Believe it or not, income producing collars are considered more conservative than cheap or zero cost collars.
The way income producing collars works is the purchase of a put and sale of a call with the call strike price positioned rather close to the current price of the underlying stock. This lower strike price generates cash greater than that required to pay for the put.
The downside is that it caps the upside potential of the stock. It is also critical to realize that the above examples do not include transaction costs such as fees and commissions.
The Key Takeaway:
The stock market is looking toppy right now. However, no one knows how long this bull market will last. If you don’t want to sell your profitable stocks, using an option collar makes sense to protect against the downside but allow for some upside to taking place.
A collar in the simultaneous purchase of a put and the sale of a call with the goal of the call sale paying for the procurement of the put.
Sometimes collars can be designed to provide a profit for the investor, but these income producing collars limit the upside potential much more than zero or low-cost collars.
Always consider the tax implications of trading options and check with a qualified tax expert. Also, it’s critical to read the CBOE’s Risk Disclosure statement if you are new in the option game.