What’s the best options strategy for a declining market?
For most investors, buying put options is the answer. Unfortunately, this strategy is one of the worst ways to protect the stocks in your portfolio right before an earnings announcement.
These misinformed self-directed investors yield to the assumption that when a stock or index is falling, volatility increases, thus benefiting the long put position. This is certainly an added benefit to the long put strategy under normal market conditions.
However, post-earnings moves can actually be met with a decrease in volatility, regardless of the direction of the stock following the earnings report. With that being said, always use caution when trading just ahead and through the earnings report of your stock of choice. This type of result is the reason why many newbie options traders are disappointed when they pick the direction correctly after an earnings report but still suffer a losing trade.
Implied volatility is pumped up before an earnings announcement, thereby inflating the price of an option. It makes perfect sense, because the demand for puts is typically greater before earnings. And we all know that higher demand translates into higher prices, regardless of what is being sold.
However, coupling a long put with a covered call provides the ultimate protective strategy, especially when you’re concerned about your stock heading into earnings. This strategy is called a collar.
Collar = (long stock + short call + long put [with different strikes])
To build a collar, the owner of 100 shares of stock buys one put option, which grants the right to sell those shares at the put’s strike price. At the same time, the stock holder sells a call option, which grants the buyer the right to buy those same shares at the call’s strike price.
Because the investor is paying and receiving premium, the collar can often be established for zero out-of-pocket cash, depending on the call and put strike prices. That means the investor is accepting a limit on potential profits in exchange for a floor on the value of their holdings. This is an ideal trade-off for a truly conservative investor.
Moreover, the results of a new study examining the use of options in a collar strategy on the PowerShares QQQ (NASDAQ: QQQ) demonstrate that a collar strategy provides superior returns to the traditional buy-and-hold strategy, while reducing risk by almost 65%.
“Loosening Your Collar: Alternative Implementations of QQQ Collars,” by Edward Szado and Thomas Schneeweis, looked at data from March 1999 to May 2009. The study concluded that over the entire 122-month period, the collar strategy returned almost 150%, while QQQ lost one-third of its value.
Additionally, the study simulated a collar strategy on a small-cap mutual fund. The return of the mutual fund collar was four times the return of the fund, while the standard deviation was about one-third lower.
Options have become a necessity for the self-directed investor, and the aforementioned studies prove the importance of integrating them into your portfolio. Don’t allow yourself to miss out on what is the future of investing for the self-directed investor.
So again, the question is this: What is the best way to protect your hard-earned investment returns?
Example: The SPDR S&P 500 ETF (NYSEArca: SPY) has rallied hard over the past several years. We own 200 shares of the benchmark ETF and would like to protect our profits. The ETF is currently trading around $206.
Step 1: So, with SPY currently trading for roughly $206, we need to sell an out-of-the-money call as our first step to protecting our profits.
The following is the options chain for September SPY options:
As you can see, the SPY $212 September call options are paying $3.40 per share, or $340 per 100 shares. You could sell call option contracts on your 200 shares, be paid $680, and then use the money to buy the put contracts you need to fully protect your stock.
Step 2: If you look at the put options chain for SPY below, you can quickly see that you have the possibility to buy the out-of-the-money put contracts at the 191 strike for roughly $3.35 per share, or $335 per 100 shares. In our case, since we want to “insure” 200 shares, we would purchase two put contracts for a cost of just $670.
In many cases, you can even end up ahead, with cash in your pocket from the call options. When buying puts for insurance it just depends on what strike you choose and how much you are willing to lose.
Here’s the catch: your upside is now limited. If SPY increases above $212 per share, at options expiration in September your stock would be called away from you. In other words, it would be sold for you, at $212 per share.
So, even if SPY advances above say $220 at September expiration, as long as you have these open call options, you are forced to sell at $212.
But remember, with this strategy, you’re insured against a disaster, and limited upside is the only shortcoming. Therefore, you use this strategy when you’re on the defensive, concerned about protecting your stocks from potential losses, and don’t see tremendous upside in the near term.
In this example, you are also protected on anything south of $191, or roughly 7.3% below the current price of $206. Of course, you could pay a bit more to increase your protection. For instance, you could buy the $199 puts for $5.02, or $502 per contract, which would protect you on anything below $199. It’s truly up to you.
At least now you know there are a wide variety of ways to use a collar strategy. Play around with the strategy, and as always, if you have any questions feel free to email me at [email protected].
If you would like to learn more about how I use options for monthly income, don’t forget to take a look at my most recent webinar.
Also, I want to remind you of an exciting event taking place this Wednesday. My colleague – Evan Lazarus – will be hosting an exclusive stock trading webinar.
Evan is a skilled trader and an outstanding instructor. And he’s prepared to share his strategies for trading fast-moving stocks.
This event is ONLY available to Wyatt Investment Research readers.
You can reserve your spot by clicking here now.