Stocks are at a crossroads…
They’ve recovered from their recent drops. But that’s making investors increasingly nervous.
Federal Reserve Chair Jerome Powell confirmed last Friday that the Fed would cut interest rates in September. That reassured the market.
But we also see a deteriorating jobs market. That suggests the Fed may be too late on rate cuts.
If economic data points to a weakening economy, we could see the market take another leg down.
So in these uncertain times, how can traders protect themselves?
Today, I want to look at a strategy that can help… and even bank you some extra cash…
Protecting Profits
One way you can protect yourself from a potential fall is an options strategy called a “collar.”
A collar is a two-pronged strategy:
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First you buy put options to protect yourself against a stock falling. By buying a put option, you gain the right to sell those shares at the put option’s strike price.
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Then to fund the purchase of those puts, you sell call options.
Depending on which strike prices you choose, the strategy can even put a credit in your account.
To see how it works, let’s say you own shares of Apple (AAPL). (Please note that this is not a trade recommendation.)
AAPL is trading at around $225. As an AAPL stockholder, you’re worried that a weakening economy could see the stock price fall. So you want to protect your profits.
You can buy a put option at $220. That gives you the right to sell your AAPL shares at $220 until the option expires (lower red line on the chart below).
Apple (AAPL)
Source: eSignal
For that right, you pay a premium – the cost of the put option.
The closer the strike price is to the current share price, the more expensive the option will be. Likewise, the cost will rise the further out the option’s expiry date is.
So in our AAPL example, a put option with a strike price of $220 with around two months until expiry costs you $4.50.
Each option contract is for 100 shares, so you’d end up paying $450.
Yet you might not like the idea of paying so much for insurance against the stock falling.
And that’s where the second leg of the strategy comes into play…
Offsetting the Cost
To offset the cost of buying the put option, you can sell a call option with a $230 strike price (the upper red line on the chart).
Take another look:
Apple (AAPL)
Source: eSignal
For selling that option with around two months until expiry, you receive $7.50 (or $750 per contract).
Note that you need to use the same expiry dates for your put and call options. You also need to place your trades at the same time.
In this case, the premium received from writing the call option ($750 per contract) more than offsets the cost of buying the put option ($450 per contract).
So you’ve protected your AAPL profits and banked $300 per contract in the process.
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A Worthwhile Tool
The one potential downside to this protective strategy is if the expected fall doesn’t come.
That’s because selling the call option comes with obligations.
If the option gets exercised, you must hand over your shares at the $230 strike price – even if the stock is trading much higher.
So if AAPL keeps rallying, you’re locked into selling your AAPL shares at $230 until the option expires.
That said, you can always buy the call option back if that leg of the trade starts moving against you.
Like all strategies, a collar is a trade-off…
Buying the put option gives you some insurance in case the stock falls. You can sell your shares at the option’s strike price up until the option’s expiry – even if the shares fall to zero.
Additionally, the sold call option can fund the cost of the put options and put some extra cash in your pocket. But you could miss out on profits if the stock starts to rally.
So it all depends on finding the right setup to use this strategy.
But the collar is a worthwhile strategy to have in your toolbox, especially in uncertain times.
Happy Trading,
Larry Benedict
Editor, Trading With Larry Benedict