The S&P 500 just hit another all-time high.
As a result, the questions have been rolling in here at Wyatt Investment Research.
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 the ultimate protective strategy. Why? Because, unlike buying a put for protection and spending lots of money to do so, you 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.
The strategy is known as a collar strategy.
Also, known as a “hedge wrapper,” collars are a protective strategy that is 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, 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 tradeoff for a truly conservative investor.
Confused yet? Let me explain. Because again, using this form of protective strategy will only serve to increase your invesmtent 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 it does every year or two. When we see those, we get a little anxious wondering if this is the big one and start second guessing ourselves. The real problem is when we get one of those calamities that shaves off 30%, 40% or 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; the ETF is currently trading for $198.
Step 1: So, with SPY currently trading for roughly $198, 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 $205 September call options are paying $0.54 per share or $54 per 100 shares. You could sell call option contracts on your 200 shares, be paid $108, 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 187 strike for $1.11 per share or $110 per 100 shares. In our case, since we want to “insure” 200 shares, we would purchase 2 put contracts for a cost of just $220. In many cases, you can even end up ahead, with cash in your pocket from the call options, while buying puts for insurance.
Here’s the catch . . . your upside is now limited. If SPY increases above $205 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 $205 per share. So, even if SPY advances to $210 or higher, as long as you have these open 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 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 $187. Of course, you could pay a bit more to increase your protection. For instance, you could buy the $190 puts for $1.50 or $150 per contract and that would protect you on anything below $190. It’s truly up to you. At least now you know there is a wide variety of choices.
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, don’t forget to take a look at my most recent webinar.