We’ve seen huge gains in tech stocks this year. So you may be sitting on outsized gains… and nervous about giving back a chunk of those profits if the market goes south.
One way to protect yourself from potential falls is an options strategy called a “collar” – also called a “protective collar.”
A collar is a two-pronged strategy. You buy put options to protect yourself against a stock falling. To help fund the purchase of those puts, you also write (sell) call options.
Depending on the strike prices of the put and call options, you can work the strategy so that there is little to no financial outlay involved. You might even generate a credit.
So today, let’s take a closer look at how to use this strategy.
To see how it works, we’ll consider Netflix (NFLX), which has been on an absolute tear. (Please note that this is an illustration, not a recommendation.)
Protecting Your Profits
NFLX is trading around $445. And the Relative Strength Index (RSI) says that it is overbought (red circle in the chart below).
So you may be worried that it is vulnerable to a fall.
If you are sitting on sizeable gains, you decide that you want to protect your profits…
One way to do that is by buying a put option. By buying a put option (“1” on the chart), you lock in a strike price.
If the stock falls below that price, you can still sell your NFLX shares for the strike price and protect your profits.
Netflix (NFLX)
Source: e-Signal
As the option buyer, the right to exercise that option and sell your shares is yours. For that right, you pay a premium – the cost of the put options.
In our example, you decide that you want to buy a put option with a strike price of $420 with one month until expiry. That costs you $15.
So you can sell your NFLX shares at $420 until the option expires in a month’s time. At 100 shares per options contract, that $15 equates to $1,500 per contract plus any broker’s commission.
Keep in mind, the price of the premium increases the closer the strike price is to the current share price and the further out the expiry date is.
For comparison, a put option with a $430 strike price and two months until expiry might cost roughly $25 – or $2,500 per contract.
And this is where our second leg of the strategy comes in to help reduce this expense…
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Offset the Cost
To help offset the cost of buying your put options, you decide to add another leg. You write a call option (“2” on the chart).
Take another look:
Netflix (NFLX)
Source: e-Signal
The important thing to remember is that writing options comes with obligations…
In this example, you could write (sell) your call options at $440. If the buyer exercises the options, you will have to sell them your shares at $440 – even if the stock price is trading much higher.
So in this collar trade, you decide to reduce the chance of the options being exercised by writing them at a strike price of $470. In exchange, you receive $15 (or $1,500 per contract), less any broker’s commissions.
(Note that you need to use the same expiry dates for both your bought put and written call options. You also need to place your trades simultaneously.)
In this case, the premium received from writing the call options offsets the cost of buying the put options.
Yet as I mentioned, this collar strategy comes with an obligation – and thus a limitation.
If NFLX continues to rally, then you are locked into selling your shares at $470 – even if NFLX jumped to $500 or higher.
So by writing your call options, you are giving up potential profits if NFLX continues to soar.
But remember that the reason you are doing this collar strategy is to protect existing profits from a stock that looks vulnerable to a fall.
If NFLX tanks down to $380 or even lower, then you can still sell your shares at $420 right up until the option expires.
Regards,
Larry Benedict
Editor, Trading With Larry Benedict
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Have you ever used a collar strategy? Share your experience with us at [email protected].