My Favorite Way to Protect Hard-Earned Profits

Happy birthday, bull market!bull-market

Six years and counting.

Since hitting a 12-year low on March 9, 2009, the S&P 500 has steadily climbed higher – 207% to be exact. No matter the reason, the longevity of the advance has been impressive. But, how long will it last?

Unfortunately, no one knows, and if they say they do, well, you are being sold snake oil.

As an options trader, I don’t believe in hypotheticals. I only believe in statistics. And it’s those statistics that allow me to place educated, highly-informed trades. Probabilities, standard-deviations and mean-reversions guide my decisions. Nothing more, nothing less.

It’s a strategy that is not uncommon to the average professional options trader. More importantly, it’s a strategy that has been used successfully and predominantly by options professionals for years to protect hard-earned profits.

But for some reason the average investor has not factored into the equation, which leads me back to the current market environment.

The 24-hour, news-driven drivel is now calling for a pullback. Certainly the S&P 500 (NYSE: SPY) is showing signs of short-term weakness, but again, no one knows the ultimate direction.

SPY-S&P-500-SPDR-chart

However, as investors, we can’t ignore the 207% gain over the past six years.

So, the question on everyone’s mind: What is the best way to protect my investment returns?

For most individual investors, buying put options is the answer. Unfortunately, this strategy is one of the worst ways to protect the stocks in your portfolio.

However, coupling a long put with a simple covered call strategy provides, in my opinion, the best protective strategy.

Why?

Because unlike spending lots of money to buy a put for protection, we can insure a stock against a decline without the need to spend much, if any, capital. And in my opinion, that’s worth knowing about.

This strategy is known as a collar.

A collar is a protective strategy that is typically implemented after a stock or ETF has experienced a substantial gain.

To build a collar, the owner of at least 100 shares of an asset buys one out-of-the-money put option, which grants the right to sell those shares at the put’s strike price. At the same time, the stock holder sells an out-of-the-money call option, which grants the buyer the right to buy those same shares at the call’s strike price.

Collar = (long stock + out-of-the-money short call + out-of-the-money long put [with different strikes]) 

Because the investor is paying and receiving premium, a 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 his holdings.

This is an ideal tradeoff for a truly conservative investor. Using this form of protective strategy will only serve to increase investment returns going forward, and that’s always our goal as individual investors.

Nothing feels better than being invested in stocks when they are going up. The problem arises, however, when the market decides to take one of those classic corrections. When we see a correction, we get a little anxious wondering if this is the big one. We start second guessing ourselves. The real problem is when we get one of those calamities that shave off 30%, 40% or even 50%.

So again, the question is this: What is the best way to protect my hard-earned investment returns?

Example: The S&P 500 (NYSE: SPY) has rallied hard over the past several years. We own 200 shares of the benchmark ETF and would like to protect our profits. SPY is currently trading for around $205.

Step 1: So, with SPY currently trading for roughly $205, 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 May SPY options.

May-SPY-options-chain

As you can see, the SPY May 215 call options are paying $0.69 per share, or $69 per 100 shares. You could sell call option contracts on your 200 shares and be paid $138, 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 185 strike for roughly $1.33 per share, or $133 per 100 shares. In our case, since we want to “insure” 200 shares, we would purchase two put contracts for a cost of just $266. In many cases, you can even end up ahead, with cash in your pocket from the call options, while buying puts for insurance.

May-SPY-put-options-chain

Here’s the catch. Your upside is now limited.

If SPY increases above $215 per share, at options expiration in May your stock would be called away from you. In other words, it would be sold for you, at $215 per share.

So, even if SPY advances to $220 or higher, as long as you have the 205 call options, you are forced to sell at $205.

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 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 $185, or a 9.8% decline from the current price of $205.

Of course, you could pay a bit more to increase your protection. For instance, you could buy the $190 puts for $1.91, or $191 per contract, and that would protect you on anything below $190. If you want to spend less or nothing at all, you can lower your strike. It’s truly up to you.

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.

If you would like to learn more about how I use options for monthly income, please check out the following link.

Published by Wyatt Investment Research at