Even in the strongest of rallies, a stock can experience a pullback. And understanding that downturns are a natural part of any market doesn’t make them any more fun. Plus, there’s also the possibility that the pullback might actually be the end of the rally altogether, and the start of a bear market.
That’s why it’s prudent to learn ways to protect your stock from a drop in price that is greater than you’re willing to accept. If you’re an options trader, one way of doing this, with little to no out-of-pocket expense (not including transaction costs), is with an option strategy called a collar.
Besides the stock you’re looking to protect, a collar consists of two options from the same expiration period: a long out-of-the-money (OTM) put, and a short OTM call, which is used to help cover the cost of the put. If it helps, think about the collar as the combination of a covered call and a protective put.
And remember—a standard options contract controls 100 shares of stock. So you would buy one put and sell one call for every 100 shares of stock you wish to protect. Let’s dissect the collar, beginning with the put option side of things.
The following, like all of our strategy discussions, is strictly for educational purposes only. It is not, and should not be considered, individualized advice or a recommendation. Options trading involves unique risks and is not suitable for all investors. Collars and other multiple-leg option strategies can entail substantial transaction costs, including multiple commissions, which may impact any potential return.
Buying a Protective Put
Long put options aren’t just for those who are bearish. Buying puts can also be valuable if you’re bullish (which, if you own a stock, you’re likely expecting it to go higher), but cautious and looking for a measure of short-term protection against an unforeseen drop in price. While it’s not an actual insurance policy, buying puts can help you pre-define your maximum loss, depending on your choice of strikes.
In terms of strike price selection, there’s no right answer, except to say your protection kicks in at your strike price. But the higher the strike, the higher the premium you pay.
So let’s say your stock is trading at $55 and you buy the 52 put for $0.40. (See the payout graph in figure 1.) You’ve now limited your potential loss to $3.40 (the $3 difference between the stock’s price and the strike price, plus the $0.40 you paid for the put, plus transaction costs.) Since the options multiplier is 100, your maximum loss is limited to $340, plus transaction costs.
Adding the Covered Call
While the cost of the put may not seem overly excessive, buying the protection month after month (if you choose to) can really add up, especially if the implied volatility (IV) rises. So to lower the cost of buying the puts you can bring in premium by selling an OTM call. Once all three pieces are in place (long stock, long OTM put, and short OTM call) you have the collar. For instance, let’s say we sell the 58 call for $0.40. See figure 2.
Selling a call that’s about the same distance OTM as the put might bring in about the same amount of premium, but in general, it’s likely to be less, due to volatility skew—the IV of an OTM put is generally higher than the OTM call And as IV rises, so does premium.
If you get the call to completely cover the cost of the put, as in the example above, then you have what’s known as a “zero cost” collar. Depending on your objectives, you can choose different strikes in order to get a price that works for you.
But, just like the put limits your risk should the stock price drop below your put strike, the short call caps your potential profit on the stock. Think of the put as a “floor” beneath your stock, and the call as a “ceiling.” Your choice of where you put the floor and ceiling determines the overall risk/reward of your position.
What happens if the stock starts moving? Keep in mind that by making adjustments you have the ability to raise the floor and raise the ceiling to give your stock room to grow. Rolling your options to higher strikes and further out in time accommodates a stock that’s still trending up. If both options are still OTM as expiration nears, you can roll both options into deferred-month contracts to keep some protection in place.
And if the stock does indeed pull back below your put strike? You could roll the put into another strike, or you could exercise your put, knowing that your loss was limited. Keep in mind that rolling will entail additional transaction costs, including multiple commissions, which will impact any potential return.
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