put-options

Earnings season is upon us.

And with earnings season comes the oft-asked question from our loyal readers, “What is the best way to protect my returns in case of a bad earnings release?”

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

However, coupling a long put with a covered call provides the ultimate protective strategy. Why? Because, unlike buying a put for protection, you can insure a stock against a decline without the need to spend much, if any, capital.

To build a collar, the owner of at least 100 shares of stock 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.

Example:

Home Depot (NYSE: HD) comes out with earnings tomorrow and you own 200 shares of the home improvement retailer; the stock is currently trading for $77.

Step 1: So, with Microsoft currently trading for roughly $77, we need to sell an out-of-the-money call as our first step to protecting our profits. Home Depot’s $80 June 2014 call options are paying $0.70 per share, or $70 per 100 shares. You could sell call option contracts on your 200 shares, be paid $140, and then use the money to buy the put contracts you need to fully protect your stock.

Step 2: You can then buy the out-of-the-money put contracts at the June 72.5 strike for $0.50 per share, or $50 per 100 shares. In our case, since we want to “insure” 200 shares, we would purchase two put contracts for a cost of just $100.

In this case, as well as many others, you will end up ahead, with cash in your pocket from the call options, while buying put options for insurance. We will make $40 ($140 for every $100 invested) from this collar.

Here’s the catch: your upside is now limited. If Home Depot advances above $80 per share, at options expiration in June your stock would be called away from you — in other words, it would be sold for you, at $80 per share. So, even if Home Depot advances to $85 or higher, as long as you have these open call options, you are forced to sell at $80.

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 our case, any move below $7.50 and the position will be fully covered.

The use of collars, particularly around earnings season, are becoming more and more widespread among individual investors.

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. The study was conducted by the Isenberg School of Management’s Center for International Securities and Derivatives Markets (CISDM) at the University of Massachusetts.

Put options have become a necessity for the individual 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 individual investor.

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Published by Wyatt Investment Research at