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Income investors often ask about my favorite way to protect returns.
For most individual investors, buying put options is the answer. Unfortunately, this strategy is one of the worst ways to protect the stocks in your portfolio.
However, coupling a long put with a covered call provides the ultimate protective strategy. Why? Because, unlike buying a put for protection, you can insure a stock against a decline without the need to spend much, if any, capital…and in my opinion, that’s worth knowing about.
To build a collar, the owner of 100 stock shares buys one out-of-the-money put option, which grants the right to sell those shares at the put’s strike price. At the same time, the stock holder sells an out-of-the-money call option, which grants the buyer the right to buy those same shares at the call’s strike price.
Collar = (long stock + out-of-the-money short call + out-of-the-money long put [with different strikes])
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.
Example: Microsoft has rallied 15% over the past several months. We own 200 shares of Microsoft; the stock is currently trading for $38.
Step 1: So, with Microsoft currently trading for roughly $38, we need to sell an out-of-the-money call as our first step to protecting our profits. Microsoft $40 May 2014 call options are paying $0.65 per share or $65 per 100 shares. You could sell call option contracts on your 200 shares, be paid $130, and then use the money to buy the put contracts you need to fully protect your stock.
Step 2: You can buy the out-of-the-money put contracts at the May 36 strike for $0.77 per share or $77 per 100 shares. In our case, since we want to “insure” 200 shares, we would purchase 2 put contracts for a cost of just $154. In many cases, you can even end up ahead, with cash in your pocket from the call options, while buying puts for insurance.
Here’s the catch…your upside is now limited. If Microsoft increases above $40 per share, at options expiration in May your stock would be called away from you — in other words, it would be sold for you, at $40 per share. So, even if Microsoft advances to $45 or higher, as long as you have these open call options, you are forced to sell at $45.
But remember, with this strategy, you’re insured against a disaster, and limited upside is the only shortcoming. Therefore, you use this strategy when you’re on the defensive, concerned about protecting your stocks from potential losses, and don’t see tremendous upside in the near term.
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.
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