Almost every day, I’m asked, “how do I protect my profits using options?”
But the question has been rolling in far more frequently as of late, so I’m going to go over my favorite strategy, step-by-step, for protecting profits without giving up potential future returns.
I mean, it’s no surprise to me that protecting profits is a major concern for intelligent investors right now. As we all know, the market has surged as of late. In fact, the S&P has doubled from the pandemic low, the second fastest doubling in market history.
But, when taking a closer look, the returns aren’t as great as they seem on the surface. Approximately 40% of S&P 500 stocks are below their 200-day moving average. Typically, this type of market action indicates bear market action. Yet, again, the S&P 500 continues to defy what’s going on below the surface.
And it’s because 40% of the S&P 500 is technology-based stocks. Hence, the current 17.6% year-to-date return in 2021.
So again, it doesn’t surprise me that the emails are piling in on how to protect profits.
Most investors simply buy puts to protect returns. Unfortunately, that’s one of the worst choices.
The Protective Collar Option Strategy
A far better alternative and one that most professionals prefer is an options strategy known as a collar. 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?
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 to successful, long-term investing is a disciplined approach to risk-management. Without it, even the best strategies are inevitably doomed.
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 of it as a covered call coupled with a long put.
- 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 “3” 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.
Again, I’m going to use Apple (AAPL) for my example. The tech stalwart has seen incredible gains over the past year and is one of the key stocks to lead the charge in the S&P 500 since the pandemic low.
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 and want some downside protection, specifically over the short to intermediate-term.
The stock is currently trading for 147.97.
- With AAPL currently trading for 147.97, 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 options that are due to expire in 36 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.
As a result, I try to sell a call with a delta somewhere around .30. The AAPL 155 August call option with a delta of 0.31 fits the bill. We can sell the 155 call option in August for $2.36, or $236 per call. We can now use the $236 from the call sold to help finance the put contract needed to achieve our goal of protecting returns.
- 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 in expiration? 60 days? 120 days? It really is up to you to decide.
I prefer to going out as far as I can without paying too much for my protective put.
I’m going to go out to the October expiration cycle with 92 days left until expiration. I plan on buying the 135 puts for roughly $2.94, or $294 per put contract.
This means that almost the entire cost of the October 135 puts will be covered by selling the August 155 calls.
Total Cost: October 135 puts ($293) – August 155 calls ($236) = $57 debit
And, we can actually add to our return, by selling more calls in September and October, while still maintaining protection through October.
So, as it stands our upside return is limited to 155 over the next 36 days. If AAPL pushes above 155 per share, at August expiration, our stock would be called away. Basically, you would lock in any capital gains up to the price of 155. With AAPL currently trading for roughly 148, you would tack an additional $7, or 4.7% to your overall return.
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 135 (where we purchased our put option). Essentially, you would only give up 7.4% of your overall returns and insure your position against a sharp pullback.
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 toolbelt.
As always, if you have any questions please feel free to email me.