Market Beat: Collaring your stocks
With the stock market at record high levels, many people like to learn about ways to hedge their positions and protect their profits. The term “hedging” goes back to medieval times when property owners would plant hedges around their home like a fence for protection.
In general, most investors should stay invested for the long haul and ride out the periods of inevitable market volatility. Currently we are in one of the longest bull markets and economic expansions in history. At some point, we will experience another economic recession and they are usually accompanied by bear markets. The terms “bull” and “bear” markets go back to early California history when they would stage fights between bulls and grizzly bears. The bulls would strike up with their horns while the California grizzlies would stand up and strike down with their paws, so bull markets go up and bear markets go down.
One way of protecting positions is by using options. Options are certainly not suitable for all investors. A common options strategy is known as a collar. To put on a collar, you sell a call option and use the funds received from the sale of the call option to purchase a put option. It’s called a collar because you limit your upside potential by selling the call and your downside by purchasing the put.
When you sell a call, you are obligated to deliver your stock or ETF at the strike price by the expiration date if the underlying is above that price. If you purchase a put option you have the right, but not the obligation to sell your holding at the strike price by the expiration date.
Typically, collars are put on for a credit, meaning that you receive cash for establishing the position and you keep that premium if the underlying stays in between the two strike prices that you select. You can also put them on at neutral cost or for a debit, that all depends on the strike prices that you choose to limit the upside and the downside.
When you select the expiration date you can determine how long the collar will stay in place. Some investors like to collar holdings around earnings reports or other news driven economic events. Options can be very useful portfolio management tools, but also require some sophistication to use properly and the risks and rewards need to be fully understood.
Kenneth Roberts is a Truckee-based Registered Investment Advisor. Information is at his blog at http://www.sellacalloption.com or 775-657-8065. The mention of securities should not be considered an offer to sell or solicitation to buy investments mentioned. Consult your investment professional to understand the risks and/or how the purchase or sale of these investments may be implemented to meet your investment goals. Past performance is no guarantee of future results.