Losing money in the stock market isn’t fun. However, if you want to earn money on your savings, then some degree of risk is necessary.
For most of the world, there is only one way to invest, and that’s from the long side. They buy equities, commodities, currencies, bonds, interest-earning cash equivalents (certificates of deposit), etc. The goal is to be well diversified among asset classes. Diversification is also a well-accepted method for reducing risk and providing investors with a path to success.
The problem is that there is no investor protection when the bear market arrives, and large losses are possible when various assets decline in tandem. Diversification among asset classes is not totally passé, but with globalization becoming dominant, asset classes are more correlated than in earlier times.
Investors deserve something better than relying on diversification. And something better is available.
For investors who cannot afford to lose, or who consider preservation of capital to be their primary consideration when investing, there is an easy-to-understand investing strategy that is guaranteed to limit losses to an acceptable level.
To pay for owning what amounts to an insurance policy on an investment portfolio, the investor sacrifices the possibility of earning a large return. In other words, accept limited profits, and in return you receive a guarantee that losses are limited. This works for the conservative (or fearful) investor, and it’s worth considering if you are among those who cannot afford to lose.
Option Collars
I don’t offer a solution for investors who are unwilling to lose any money. When seeking a return, some risk is required. But if you are looking for a strategy that limits losses, the option collar is for you.
Many don’t consider options to be risk-reducing investment tools, but they can be used that way.
When you own a collar, the trade has three components:
1. Buy 100 shares
2. Buy one put option
3. Sell one call option
Let’s say you have $100,000 to invest in the stock market. For this discussion, any other assets are ignored, but you can adopt collars with some of them.
To own a diversified stock portfolio, you bought 2,000 shares of PowerShares QQQ Trust (NASDAQ: QQQQ), an exchange-traded fund (ETF) that mimics the performance of the Nasdaq 100 Index (NDX).
You may prefer to own shares of larger companies than those represented by the QQQQ. In that case, choose large companies, such as those represented by the S&P 500 Index (SPX), using the SPDR S&P 500 ETF (NYSE: SPY), or perhaps mid-size companies with the SPDR S&P MidCap 400 ETF (NYSE: MDY). (Note: This example demonstrates how collars work and is NOT a recommendation to buy QQQQ.)
There are several steps involved to get the position you want to own. Assuming you do not want to trade often, let’s use six-month options.
Buy one put option for each 100 shares of QQQQ. Choose the put strike price (the price at which you are guaranteed to be able to sell your shares, no matter how low they may trade).
Next, choose the call strike price (the maximum price at which you can sell your shares, no matter how high they may rise). The call is sold to finance the purchase of the puts. If you don’t sell calls, the insurance policy is far too costly and the likely result is a monetary loss.
With QQQQ trading at $48.16, you may choose to own December 46 puts and sell December 49 calls. The put can be bought and the call sold for a small cash credit. That means there is no out of pocket cost (in this example) to establish the option portion of the collar.
QQQQ pays a quarterly dividend, usually near 5 cents. You collect that dividend three times, but depending on the share price in December, you may not collect that final dividend.
Example:
* QQQQ is $48.16. Buy 2,000 shares, investing $96,320
* Buy 20 QQQQ Dec 46 Puts. Cost: $321 each
* Sell 20 QQQQ Dec 49 Calls. Collect: $334 each
* Option credit: 13 cents
* Final cost $48.03 per share, before commissions
* Dividends: 15 cent (estimated)
* Maximum selling price is $49, earning a profit of 97 cents per share, or $1.12 after dividends (2.3%)
* Minimum selling price is $46, for a loss of $2.03 per share, or $1.88 after dividends (3.9%)
Is the Collar Right for You?
The collar owner gains the benefits of limited losses in exchange for limited profits. This does not suit everyone. Would you be willing to own an investment, and hold it for over six months when the maximum return on your investment is 2.33%? Does the fact that your portfolio is protected and you cannot lose more than 3.9% make any difference in that decision? The return may not excite you, but it does come with a guaranteed floor for your portfolio. That’s not so easy to find.
The good part about collars is that you can choose your own “deductible” by varying the put strike price. Similarly, by selling a different call, there’s the possibility of higher profits.
The idea behind this post is to be certain that individual investors are more aware of their trading opportunities. This is not intended to be sufficient information to enable you to trade the collar. Please learn before attempting to earn.
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