Since joining Dent Research to contribute to The Rich Investor and run Instant Income Alert, I’ve received a lot of questions on how I’m preparing for the next bear market, including what I’ll do once the bottom falls out.
What strikes me the most isn’t the worry itself – it’s important to consider worst-case scenarios – but how adamant people are that a bear market is definitely going to happen.
Why are they so sure?
The fact is, people are scared. No one wants to live through another 2008-09 meltdown. Great Recession 2.0? No thanks.
Being one of the resident option experts at Dent Research, it’s my goal and ambition to enlighten you to alternative, yet profitable, trading strategies that have brought me success throughout my 27-year investing career.
These are two fantastic option trading strategies that can take your investing game to the next level.
Today, I’ll highlight an option trading strategy that can be used to help offset downside risk in one of your bullish stock positions.
This strategy combines two option strategies into one, and it’s called a “collar.”
Downside Protection With Upside Potential
The collar is a great way to protect your downside while leaving room for capital appreciation on the upside.
It’s a combination of a “covered call” and a “protective put.”
Maybe some of you have heard of these strategies. For those that haven’t, here’s a quick rundown:
- Buying a protective put option offers you the opportunity to sell your stock at a price of your choosing for a specified period, regardless of where the stock may currently trade.
- For instance, let’s say you bought a stock a few years ago for $50 per share and it’s now $100 per share.You want to protect part of your gains, so you decide that $75 is the point where you’d bail out if the stock drops.
- To do that, you buy a $75 put option for its going rate. That means even if the stock falls below $75 by the expiration date, you can sell it for $75 per share.It offers peace of mind knowing that you’re protected, even if the stock goes to zero.
- Sure, you could place a stop-loss order with your broker sell the shares at $75 if the stock falls to that level. But what happens if there’s a fast-moving catastrophe, and the stock blasts through your stop level before anyone can do anything? You may get filled at $50 for all you know.Buying the protective put option guarantees you a sale price at $75.
- You’ll have to pay for the option at its going rate, though. Let’s say it costs $3 per contract. This is a cash outlay of $300 ($3 per contract x $100 option multiplier). This covers you for every 100 shares of stock you own. If you have 500 shares, you can choose to buy five put-option contracts. That would cost $1,500.
- If the stock falls to $50 at expiration, you still get to sell your shares for $75, but you must subtract out the $3 cost of the option, making $72 per share your effective exit point.
If the stock never breaches $75 before the option expires, you forfeit your $300 per contract. However, your stock holdings remain. You can opt to buy another round of protective puts if you desire.
Now, let’s break down the “covered call.”
- For every 100 shares of stock you own, you can choose to sell a call option with a strike price commensurate with the price at which you’d like to cash out.
- For the shares you bought at $50 apiece, you’ve decided that $120 is the highest they’ll go.
- You can sell a call option for the $120 strike price and collect the going rate. Let’s say that’s also $3 per contract.In this case, you’d collect $300 for each call option you sell. If you have 500 shares, you can sell five call options and collect $1,500.If the stock moves above $120 by expiration, you’ll be obligated to sell your shares at $120. Even if it moves to $140 per share, you still have to sell them at $120 each.If the stock doesn’t move above $120 by expiration, your obligation will disappear. You can then sell another round of covered calls and collect another round of cash.
- This is a great way to add a new source of income to your portfolio. Your stock positions become an income-generating machine.
- But a word of caution: Choose a sell point that you’d be comfortable unloading your shares, as the stock could conceivably rally higher after you cash out!
Putting It All Together
Combining the protective put and the covered call effectively “collars” your long stock positions on the upside and downside.
It gives you an automatic out on either end that you’ve set ahead of time and at comfortable price points.
In this example, the purchase price of the put option and the sale price of the call option are the same, which gives you neither a debit or a credit. This is a “no-money” way to protect yourself against downside and still allow for further upside.
As long as you create collars for no money (or even better, for a credit, which means the premiums you collect on your calls outweigh the upfront cost on the puts), you can conceivably keep the strategy going for years on end, until one side gives way. Hopefully the upside wins out!
Although a double option strategy might sound a little tedious, it’s actually quite simple to execute. So when you’re worried about a pending downturn or even panicking over the unknowns, this strategy gives you a real measure of control in an increasingly chaotic market.