by Tyler Craig | October 16, 2013 8:28 am
With earnings season descending upon Wall Street, market watchers everywhere will be receiving a slew of new data to mull over in the coming weeks. Regardless of the numbers reported, shareholders of all stripes will be rooting for a positive reaction in the stock price of whatever companies they own.
Earnings season reveals the fickle nature of the market, with earnings beats sometimes leading to selloffs and earnings misses sometimes leading to rallies.
Given the elevated uncertainty and volatility surrounding these events, holding stocks into the release is always a bit of a gamble. Every quarter, there is a handful of companies that blow out the numbers and deliver massive overnight profits to shareholders. And then there are the unlucky few who get taken out and beaten mercilessly.
Fortunately, the options market provides a simple way for protecting yourself from the earnings drama — the collar strategy.
The collar consists of selling one call option and buying one put option of the same expiration cycle for every 100 shares of stock you own. Since investment bank Goldman Sachs (GS) is set to report earnings Thursday after the bell, we’ll use it as an example.
Suppose you own 100 shares of GS and have enjoyed its 24% year-to-date gain. But, with the stock showing some technical signs of deterioration, you want to protect against a potential post-earnings plunge. Many traders would head to the options market and buy an out-of-the-money put option.
For example, with GS currently trading for $157.63, you could buy the Nov 155 put for $3.75. However, the purchase of the put would require a capital outlay of $375, or roughly 2.4% of the value of your entire 100-share position ($375/$15,763).
While paying 2.4% doesn’t appear expensive at first blush, keep in mind this protection only lasts for one month. Were you to repurchase the put every month, you would be paying about $4,500 after one year, which would require the stock to rise by 29% just to breakeven.
Here’s where the collar strategy comes in.
To finance the purchase of the put option, we could sell an out-of-the-money call option, such as the Nov 160 call for $3.75. In exchange for obligating yourself to sell the stock above $160 — which limits your profit potential — the premium received pays the cost of the 150 put.
When a collar is entered where the money received from the short call is equal to or higher than the money paid for the long put, it is considered a no cost collar.
Let’s compare the potential profit and loss of your 100-share GS position to before and after entering the collar. Before adding the collar, your 100 shares of GS had a max potential loss of $15,763 and unlimited potential reward.
After entering the collar — selling the Nov 160 call and buying the Nov 155 put — the loss was limited to $263 ($157.63 – $155) and the max gain was limited to $237 ($160 – $157.63).
The range of outcomes and potential volatility in your GS position is drastically reduced with the addition of the collar. The percentage of your position at risk dropped from 100% to 1.5%. What’s more, the risk reduction was attainable at no cost (aside from paying commission, of course).
Consider collars anytime you’re beset with the investing jitters, earnings or otherwise.
As of this writing, Tyler Craig did not hold a position in any of the aforementioned securities.
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