Options trading equal choices, and lots of them. While some enter the options arena with a gambler’s mentality and dollar signs in their eyes, others flock to options in an attempt to reduce risk. Traders on the more conservative side of things will find a variety of strategies that can reduce risk, lock in gains, and otherwise minimize one’s exposure to adverse moves in a stock position.
The risk reduction quality of an option becomes particularly appealing in times of heightened uncertainty. And there’s rarely anything more uncertain than earnings season when quarterly announcements and increased volatility seem to go hand in hand.
Many stock owners would benefit from acquiring some type of protection before earnings are announced. While it is common to buy a put or sell a covered call, it can make more sense to try a Collar Trade on your long stock holding.
The collar is an interesting alternative because it involves both purchasing a put and selling a covered call. Here’s an example using one of the hottest momentum stocks in the market, Netflix (NASDAQ: NFLX).
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Suppose I own 100 shares of NFLX and want to acquire some protection going into its earnings announcement scheduled for Monday April 25. Let’s say NFLX was trading at $247. I could enter a collar by selling the NFLX May 260 Call for $9.70 and buying the NFLX May 235 Put for $9.70. Since the premium received from the call option is sufficient to pay for the put option this is referred to as a no-cost collar.
The Short Call Option
By selling the 260 call I am now obligated to sell NFLX at $260. With a current stock price of $247 this means I can still make an additional $13 per share.
The Long Put Option
By purchasing the 235 put I now have the right to sell NFLX at $235. Regardless of how far NFLX may drop post earnings I’ve effectively limited my downside exposure to $12 per share.
A useful tool that active option traders use to analyze the potential risk and reward of an option position is a risk graph. Notice in this graph how the NFLX collar both limits the upside profit potential while drastically reducing the downside risk.
Netflix (NASDAQ: NFLX) Option Collar Trade
(Source: MachTrader)
At the time of this writing Tyler Craig had no position in NFLX.
Follow Tyler Craig on Twitter@TylersTrading.
