Stocks are becoming overstretched. That means investors are starting to get nervous about a pullback…
And you may be wondering how to protect yourself during a fall.
One way to do that is by buying a put option. A put option lets you to offload your shares at the option’s strike price.
So, for example, if the strike price is at $120 and the stock falls to $110, you can sell your shares for $120 before the option expires.
But buying put options can be expensive – especially if you have many holdings to cover.
So today I want to run through a strategy that can offset that cost. And if you get it right, you might even make some money…
A Potential Fall
The strategy I’m referring to is a “protective collar.”
A collar is a two-pronged strategy:
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You buy a put option to protect yourself against a stock falling.
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You also sell a call option. This earns you some money to offset the cost of the put option.
Let’s consider JPMorgan Chase (JPM) as an example to see how it works. (Please note that this is not a trade recommendation.)
JPM is trading at around $225. You’re worried that it could slide if the economy starts to weaken. So as a stockholder, you want to protect yourself from a potential fall.
You decide to buy a put option with a strike price of $220. That means you can sell your JPM shares at $220 (lower orange line on the chart below) right up until the put option expires.
JPMorgan Chase (JPM)
Source: e-Signal
To obtain that right, you pay a premium – the cost of the put option.
(The closer the strike price is to the current share price and the more time there is until expiry, the higher that premium will be.)
Say this put option with a strike price of $220 and around 50 days until expiry costs you $5.20. Each option contract covers 100 shares, so you pay $520 for each options contract you buy.
That cost might seem hefty to you, though.
And that’s where the second leg of the strategy comes into play…
Offsetting the Cost
To help offset the cost of buying the put option, you decide to sell a call option with a strike price of $230 and 50 days to expiry. That’s the upper orange line on the chart.
Take another look:
JPMorgan Chase (JPM)
Source: e-Signal
For selling that option, you receive $5.80 (or $580 per contract).
Note that you need to use the same expiry dates for your put and call options – and be sure to place both trades at the same time.
In this example, the premium received from selling the call option ($580 per contract) is more than the cost of buying the put option ($520 per contract).
So you’ve gained protection for your JPM shares and banked a $60 credit in the process.
Here’s how this might play out…
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Understanding the Scenarios
There are essentially three different scenarios for how this protective collar might play out.
Let’s say JPM falls to $215. You can decide to exercise your put option and sell 100 shares of JPM for $220 per share. (At the same time, you may decide to buy back your call option for a nominal fee to reduce your risk.)
On the other hand, if JPM trades flat for the next 50 days, both options can expire worthless, and you’re simply left with the $60 per contract you earned.
But what if JPM rises higher?
The catch is that if JPM rallies, you’re locked into selling your JPM shares at $230 until the option expires. That’s true even if JPM surges to $240… $250… or more.
That’s why you need to choose a strike price for the call option where you’d be satisfied to hand over your shares.
Like all strategies, a collar is a trade-off…
Buying the put option allows you to sell your shares at the strike price until the option’s expiry – even if the stock falls to zero.
A sold call option can fund the cost of the put option. But it means you could miss out if the stock rallies.
Yet in uncertain times, a collar is a worthwhile strategy to have in your toolbox…
It can provide you with much-needed protection while also helping you (potentially) bank some extra cash.
Happy Trading,
Larry Benedict
Editor, Trading With Larry Benedict
P.S. Last night, I explained why I’m expecting a period of heightened volatility ahead. It has to do with a key market indicator that just triggered… And the turning point could be as early as next week.
We’ve seen this particular scenario play out four times in the last 40 years. And based on history, anyone who sticks with a “buy and hold” method during this “chaos period” could face years of subpar returns.
Worse still… they could be forced to push back their retirement.
That’s why I want all my readers to be prepared with my blueprint for profiting during volatility. I shared my favorite strategy last night.
So if you’re worried about protecting your portfolio, then don’t delay… The replay of last night’s event is only available for a brief window. You can check out my presentation here.