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Protect Your Stocks Using Put Options - The Collar Strategy
The average stock trader will simply buy stocks based on some selection criteria, and then for the most part, will simply hope for the best that the stock will go up in value, and in a bull market there's a good chance that will happen.
The average stock trader will simply buy stocks based on some selection criteria, and then for the most part, will simply hope for the best that the stock will go up in value, and in a bull market there’s a good chance that will happen.
Statistics show that in a bull market about 75% of the stocks will follow the general trend and go up, and in a bear market 75% will also go down. Trading with the trend is the best way to trade as 9 out of 12 stocks will follow the trend and give you the best chance of making gains on your stock purchases.
Even in a clear bear market there are reasons why some investors would not want to sell their stocks, this could be for tax problems or because they inherited the stock from a relative. Without taking some action they could suffer a large loss, but fortunatley by using options some downside protection can be obtained. Using Call and Put options in two strategies called Covered Call and the Married Put the losses can be limited.
Option trading can be very confusing and difficult at 1st, actually it’s not that complicated once you have had a good education in the subject. However if terms like Put and Call Option, Married Put and Covered Call don’t mean anything to you, don’t attempt to trade options until you get that essential education in the theory.
Selling calls against your stock in 100 share increments is the basis of the covered call strategy and it can provide about a 2-7% buffer against the loss in stock price. However a bigger drop in stock price will not be compensated for using the covered call strategy, in general.
As already mentioned the covered call system only has the potential to offer about 4-7% credit when the stock goes down. Stocks have been known to quickly lose anything from 10 to 30% in a matter of days or weeks and the covered call strategy offers little protection against this sort of loss.
The better solution to providing downside stock protection is the option strategy called the Married Put. As the name suggests the PUT that you buy is used to provide protection when the stock goes down because Put options increase in value when the stock decreases in value. The term married is used because the option that is selected has to be very compatible with the stock, in other words a good match, if the strategy is to work.
There are a number of parameters that need to be considered when creating a Married Put for protection, the following list highlights the main points:
1. What strike price is selected for the Put option
2. The current stock price
3. Either in or out of the money Put options
4. Time to expiration of the Puts
Even though the married Put protection only has a limited life span if offers much more protection than the covered call. It can provide as much as 95% loss recovery in the event of a significant drop in the stock price.
The disadvantage of the Married Put strategy is that you have to buy the Put option, i.e. it costs you money, whereas the covered call is a net credit, whoever said option trading was easy?. Having said that I have not yet told you the full story of the Married Put, there’s much more. There are ways of off setting the cost of the Put so that this strategy becomes self financing and can make heaps of money when the market is very volatile.
The general idea of the Collar Trade is to combine the covered call and married Put strategy into one, this is what is called the Collar Trade. In effect you put a collar around the stock, sell a call and buy a PUT. If you do this correctly most of the cost of the Put can be offset by the credit from the covered call so you can protect your valuable stock at almost no cost. Yes this is a great strategy which the general public is unfortunately very ignorant of, and most brokers don’t understand.