Reduce Risk by 65% and Beat Buy and Hold

Earnings season has officially kicked off and many self-directed investors are getting nervous about their holdings. Combine worries about earnings season with continued European debt woes and the upcoming “sell in May” phenomenon, and you can see why investors are concerned about the intermediate-term future of their investments.

So what’s the best strategy for a declining market?

For most self-directed investors, buying put options is the answer. Unfortunately, this strategy is one of the worst ways to protect the stocks in your portfolio right before an earnings announcement.

These misinformed self-directed investors yield to the assumption that when a stock or index is falling, volatility increases thus benefiting the long put position. This is certainly an added benefit to the long put strategy under normal market conditions.

However, post-earnings moves can actually be met with a decrease in volatility regardless of the direction of the stock following the earnings report. With that being said, always use caution when trading just ahead and through the earnings report of your stock of choice. This type of result is the reason why many newbie options traders are disappointed when they pick the direction correctly after an earnings report but still suffer a losing trade.

Implied volatility is pumped up before an earnings announcement, thereby inflating the price of an option. It makes perfect sense because the demand for puts are typically greater before earnings.  And we all know that higher demand translates into higher prices, regardless of what is being sold.

However, coupling a long put with a covered call provides the ultimate protective strategy, especially when you’re concerned about your stock heading into earnings.  This strategy is called a collar:

The Collar = (long stock + short call + long put [with different strikes])

A collar is the most popular method for protecting portfolio value against a market decline.

To build a collar, the owner of 100 stock shares buys one put option, which grants the right to sell those shares at the put’s strike price.  At the same time, the stock holder sells a call option, which grants the buyer the right to buy those same shares at the call’s strike price.

Because the investor is paying and receiving premium, the collar can often be established for zero out-of-pocket cash, depending on the call and put strike prices. That means the investor is accepting a limit on potential profits in exchange for a floor on the value of their holdings. This is an ideal tradeoff for a truly conservative investor.

Moreover, the results of a new study examining the use of options in a collar strategy on the PowerShares QQQ (NASDAQ: QQQ) demonstrate that a collar strategy provides superior returns to the traditional buy-and-hold strategy while reducing risk by almost 65%.

The Options Industry Council (OIC) is pleased to note the study reaffirms the risk management potential of equity options, finding that during the entire 10-year study period, including the sub-periods around the tech bubble and credit crisis, collars significantly outperformed the QQQ, providing much needed capital protection.

“Loosening Your Collar: Alternative Implementations of QQQ Collars,” by Edward Szado and Thomas Schneeweis, looked at data from March 1999 to May 2009. The study concluded that over the entire 122-month period, the collar strategy returned almost 150%, while QQQ lost one-third of its value.

Additionally, the study simulated a collar strategy on a small-cap mutual fund. The return of the mutual fund collar was four times the return of the fund, while the standard deviation was about one-third lower. The study was conducted by the Isenberg School of Management’s Center for International Securities and Derivatives Markets (CISDM) at the University of Massachusetts.

Options have become a necessity for the self-directed investor and the aforementioned studies prove the importance of integrating them into your portfolio. Don’t allow yourself to miss out on what IS the future of investing for the self-directed investor.

Next Tuesday I will be going over several examples of how to use collars for stocks with upcoming earnings reports.

Stay tuned!