Not since the fall of 2008 have there been such wild swings in the market. The average range, measured as the percentage difference between the intraday high and low, for the S&P 500 during the first 10 trading days of August was nearly 4.25%.
This is incredibly high for an index of 500 stocks, and investors are wondering how they can protect their portfolios.
Last Wednesday, the editors here at IFII held the Debt Downgrade Teleconference, where we discussed the impact of Standard and Poor’s downgrade of U.S. debt and the impact it was having on equities, bonds, currencies, and commodities. We also provided listeners with a number of investment ideas for the near term. One strategy that I recommended to help protect your stock holdings is known as the collar.
A number of listeners were interested in further clarification regarding this strategy. Since the markets are likely to remain volatile during the coming weeks and months, I thought that this would be the perfect opportunity to elaborate on this simple, yet incredibly valuable, strategy.
Two Strategies Used Together to Provide Powerful Protection
Whenever I discuss options strategies, I find it useful to use real life examples. For today’s discussion, I will use Walt Disney Company (DIS). I have no opinion or position in DIS, but know that it is widely held, and the price action is pertinent to this discussion.
Perhaps Disney was on your watch list and you took the opportunity last week to purchase the stock at $31.75, which was an area of support established in the summer and fall of last year. The stock closed on Friday at $33.09 and you realized that, even if the stock continues to move a little higher this week, it might find near term resistance in the $35.00 to $36.00 area. This would correspond with rapidly falling 20 and 50 day moving averages over the next several days.
Covered Call Strategy
Given this assumed expectation, you might have looked at the September options on DIS late Friday and decided to sell the 35 calls at $.72. This is known as the covered call strategy. Although this limits your upside to $35.72 (strike price + premium collected in call sale), you have lowered your breakeven on the stock position to $31.03 (stock purchase at $31.75 - $.72 collected in call sale). Unfortunately, should Disney fall significantly below that price, your downside risk is unlimited.
Put Protection Strategy
Since the market has moved up and down dramatically, that unlimited downside risk may not be acceptable. Rather than selling the call, let's say you chose to purchase some insurance in the form of the 30 put.
Late Friday you could’ve bought these puts for $.67. This would allow you to capture unlimited upside should the stock return to its 2011 levels. Because you have to pay for insurance, the strategy underperforms the long stock position on the upside. In this case, your breakeven is raised to $32.42 (stock purchase at $31.75 + $.67 premium paid for put), but your downside losses are limited should the stock completely fall out of bed. The most you can lose on this strategy alone is $2.42 (strike price – stock purchase price – premium paid for put).
The collar combines both the covered call and protective put strategies. While this still limits your upside, it provides you with significantly better protection on the downside. In this case, you were actually able to execute this strategy for a $.05 credit (premium collected for call sale – premium paid for put purchase).
Because you are able to collect a $.05 credit for the trade, you are able to lower your breakeven from $31.75 to $31.70. Additionally, you have reduced your maximum loss by nearly 30% from $2.42 to $1.70 (strike price – stock purchase price + credit received for collar).
Even if Disney remains bound in the $30.00 to $35.00 range through September expiration, you will still be able to collect the $.05. This is a great deal for much improved downside protection.
In the last two weeks, implied volatility has soared, making options across the board much more expensive than they were as recently as July. This means that just purchasing put protection can be very expensive proposition. Selling an upside call greatly reduces the cost of buying insurance in a high volatility environment.
The other point, and one of the many things I love about options, is that the strategy is thoroughly customizable. If your expectations are for greater upside, then you might want to choose a higher strike call. Although you will not collect as much premium, and you might end up paying a net debit for the strategy (this would happen if the premium collected from the call sale was less than the premium paid for the put purchase), it is still worthwhile because of the excessive volatility levels priced into the options.
Generally speaking, I use the strategy to protect gains on stocks I already have a profit in rather than initiate it all as one trade. There are better choices than putting on this kind of position with a three legged strategy.
The astute reader probably noticed that the breakeven graph for the collar trade is identical to the breakeven graph of a bullish vertical spread. Vertical spreads are little beyond our discussion today, but I did address the topic back in April. You can check out that article HERE.
The bottom line is that, in a high volatility environment like we are experiencing today, a collar trade can provide you with a way to capture some additional upside while simultaneously providing cost effective downside protection. It is a great way to protect long stock gains when you can get them!
Price Shock Trader