By: Costas Bocelli — July 3, 2019
How to Build a "Safety Net" Under Your Profits
We've all been there...
We pull the trigger on a trade (maybe after an agonizing period of "paralysis by analysis"... and we're thrilled when the stock price rises.
That's a win, right?
Yes... Until your gratifying pleasure begins to turn into impatient paranoia.
Remember, you can't spend paper profits. You actually have to sell your position to capture real gains.
But if you sell too soon, you could miss out.
Let’s say you bought a stock in early 2019 for around $65.00, and today it is trading at $77.75. You are currently sitting on an unrealized $12.75 gain. This is a nice position to be in obviously. But remember, the position is still open with your profit and principal still facing at market risk.
Let’s fill in a little more detail.
Say your stock is near its 52 week high, and is set to announce earnings in a few days.
Do you think that your profits and principal are at risk? There is a degree of uncertainty as to what the earnings will be, how the market perceives the reports, and more importantly, what management has to say in the conference call.
If you prefer to continue holding the stock if possible, but are anxious going into an uncertain event such as earnings...
... there is an easy way to protect most of your profits, insulate your principal from any loss, and have the potential for additional profit.
All this can be accomplished by using a simple option strategy called a “Collar”. The strategy cost can be very cheap, free, and you may even get paid for the protection in some situations.
A Collar is designed to protect you from the possibility of large negative price movements, thus protecting the position long enough for you and your stock to digest the earnings report and the market action.
With a collar, you buy of an out of the money PUT for protection while at he same time selling an out of the money CALL to finance the cost of the PUT.
Both options trade in the same month, and in this case, you are looking for protection for July, so you'll want to do this in the front month August expiry. Your insurance policy will expire on August 16th, the third Friday of the month.
How to Create the Collar
With your stock trading at $77.75, you would look to buy the AUGUST 75 PUT for (say) a 1.55 debit... and sell the AUGUST 80 CALL for a 1.55 credit. The insurance policy can be set up for free, outlaying 0.00 (broker commission charges only)!
Buying the PUT gives you the right to sell the stock at $75, and selling the CALL obligates you to deliver your stock at $80 if you are assigned.
So far so good. All the pieces are in place. Now let's look at what this insurance doing for you, and what effects it can have on your position.
You basically face three scenarios...
Scenario #1, The Non-Event: The earnings report and management statements have no affect in the market. Your stock essentially stays unchanged around $77.75. Since the insurance collar cost you $0.00, you can either keep the collar on until expiration, or you can trade back out of it for close to what you paid, $0.00. The result was free protection going into earnings.
Scenario #2, The Stock Sells Off: If the stock trades below $75, your PUT protection kicks in, insulating any losses below 75. This is because the PUT gives you the right to sell the stock at 75. If the selloff is severe, with a drop of say 9% that would put the stock price around $70. The collar saved $5 dollars of profit. You still lose the profit from $77.75 to $75, but that's all! The unprotected stock position would have cost you almost $8 in profit.
Let's say the stock experiences a more typical selloff, perhaps in the 3-4% range.
That puts the stock at around $75. This result is still better than using no option protection. With the stock stabilizing or settling in at $75, your stock profit is reduced by 2.75. However, the collar position increases in value with the decline in stock price. You will find that you can sell out your collar position for about 1.50 credit (remember, you put it on for $0.00). This offsets the 2.75 loss from the drop in stock, reducing the loss to only 1.25. You can think of the 1.50 credit as a reduction to your stock cost basis from the purchase price of 65.
Scenario #3, The Stock Trades Higher: Ever heard the expression, “There's no free lunch”? It applies here. There is an opportunity cost to getting “free insurance” with using the collar strategy. What you have to be prepared for is that you will not be able to participate in additional stock gains above the CALL strike you sold, in this case 80. With the stock above 80, your upside profit will be capped from 77.75 to 80. You can only make an additional 2.25 or 3%. You got in at 65, but the collar will get you out at 80.
This collar strategy is ideal when you want to protect profits while taking the principal risk off the table going into an uncertain event, such as earnings. If you feel that there is a greater opportunity for more upside appreciation than downside risk, the collar strategy may not be the best risk management tool for that situation.
However, if you feel the stock has made a nice run and seems there could be a substantial risk to the downside, consider the “collar” strategy. It may be more prudent to employ the “collar” on your stock position than the “strangle” on your neck if things go bad and the stock tanks wiping out profits or even worse, your invested principal.
See you next week!