Facebook
Twitter
The S&P 500 is up 24% year-to-date, establishing record highs on almost a daily basis of late. The index has gained 41% in the last two years. And there have been very few hiccups along the way. It has now been 531 market days since a market pullback of 10% or more has occurred.
Stocks like Netflix (Nasdaq:NFLX), LinkedIn (Nasdaq: LNKD), Chipotle (NYSE: CMG) and many other have benefitted from the relentless surge.
Is it time to sell a few of these high-flyers?
Well, let’s take a look at one of the biggest bull benefactors and a personal position of mine, Elon Musk’s Tesla (Nasdaq:TSLA).
Back in late December 2012, on a recommendation from a friend, I purchased 100 shares of Tesla for my seven year-old daughter. I NEVER, and I must emphasize NEVER, buy stocks based on the recommendations of others. But my friend is the ultimate perma-bear. He would much rather short a stock than buy one. But, for the first time, at least since I’ve known him, he highly recommended buying a stock. The stock…Tesla.
The timing happened to be just right because I had some capital set aside for my daughter and was searching for a few stocks to invest in. So, I bought a few hundred shares thinking I would hold on to the stock for a few years.
But then the stock started to rise, well, exponentially.
Surprisingly, I was able to hold on to the stock as it continued to gain more and more momentum. As an options trader, the typical holding period is days, sometimes hours, but in this case the stock was purchased as a long-term holding.
But the struggle to not sell the Tesla continued as the stock became more and more overextended. And then a video surfaced back in early October of a Tesla Model S sedan that had burst into flames. Finally, too concerned to ignore the situation, I did what any sound options strategist and savvy investor would do; I added some downside protection.
I used a simple options strategy known as a collar.
The Collar = (long stock + short call + long put [with different strikes])
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.
So, on Oct. 2, I decided to use a collar on Tesla with the stock trading around $180. I wanted to protect a loss in the stock of no more than 20%…a typical bear market move.
I bought $145 puts for $15.25 and sold $220 calls for $15.50, which actually gave me a credit of $0.25 or $25. Basically my loss was limited to move down to $145. Any move more than that and I was covered by my position.
Due to the unrelenting rally, I had $18,000 in TSLA shares when I opened the collar.
But roughly a month later TSLA closed at roughly $151, down roughly 16% from the price at which I added the collar.
Here is where my collar stood. The puts were worth $19.45 and the calls were worth $4.20. So, if I wanted to close the short call leg of the collar it would cost me $420. By doing this I am left with my put position worth $1,945.
So what’s my loss?
If you take the $15,100 the shares were worth last Wednesday plus the $1,945 the puts were worth, you have a total of $17,045. But remember, we bought back the calls for $420 so we have to subtract that from the $17,045 which gives us a total of $16,625.
The $16,625 represents a loss of 7.6% loss from the $18,000 our TSLA position was worth when we added the collar. That’s far superior to the 16% loss we would have taken if we had no hedge on the position.
Being hedged gave me the breathing room to decide the best course of action. My TSLA position hedged with a collar could allow me to exit my position with an 8% loss now, or I could wait to see what happens, or if I was still bullish on TSLA, I could buy-to-close the call leg of this collar, to eliminate my upside cap. If I was even more bullish after the decline, I could sell my appreciated puts, and use those proceeds to buy more TSLA.
Given the recent advance in many of the high-flyer stocks like LinkedIn, Netflix and many others, now might be the ideal time to start looking towards a collar to keep your hard-earned gains in your pocket.