As the Best Choice blog has explained in the past, one of the most valuable uses of derivatives (like an option contract) is securing other assets. Retailers, for example, use the futures market to stabilize prices over the long term, while investors can use options as a hedge against market instability.
By taking advantage of how derivatives can move independent of, and even sometimes counter to, the market, this class of assets can go a long way toward protecting your portfolio. For example, many stock traders take advantage of a technique called the “protective collar.” Here is how it works.
What it is
First, you buy a protective put (otherwise known as a married put) on a single stock. This is a put contract for the same number of shares that you own, but with the strike price set lower than your purchase price of the stock.
Then you sell a covered call on the stock. This is a call contract that you sell for the same number of shares that you own, but with the strike price set higher than your purchase price of the stock.
For example, suppose you have purchased 100 shares of GameCo at $10 per share. To build a protective collar around it, you would buy a put contract at an $8 strike price, then sell a covered call at a $12 strike. Your stock is now collared by two options contracts on either end.
How it works
Now drill down into what that all means in execution.
A protective put gives you, the investor, a maximum threshold for loss because your sale price on the stock cannot go lower than the contract. To take the example above, your put contract gives you the right to sell 100 shares of GameCo for a minimum of $8. So, if the stock declines to any level below that, you will exercise that contract and sell your existing shares for the strike price.
This caps your losses at the difference between the purchase price and the strike price (in the example, $10 – $8 = $2) plus the premium paid.
Meanwhile, the covered call creates the opportunity for additional profit on your stock while limiting its maximum upside.
The call contract you sold requires you to sell someone your 100 shares of GameCo at $12 if the stock rises above that strike price. As a result, if the stock stays flat or goes down, the option expires worthless and you keep the premium. If the stock goes up, but not as high as $12, the option again expires worthless and you both profit from the sale and keep the premium.
If the stock rises above $12, you have capped your profit on GameCo to $2 per share (since you bought it at $10) plus the premium.
Together these two contracts form the collar around your stock. The put contract minimizes your losses while a well-calibrated call can bring in additional money from the premium (offsetting the premium paid for the put) without overly risking future profits.
How to use it
Use protective collars carefully.
That may seem like an odd warning, given that the entire purpose of a protective collar is to stabilize stock market investing. However it is important to remember that your value depends on getting those strike prices right. Set the put too low and you have paid for worthless protection. Set the call too low and you cannot make any real money off the stock.
How can you make that call? Honestly, it takes information. Where can you get that information? See our trading products!
That said, the protective collar is an incredibly valuable tool. Investing in single stocks is always a risky position. They are jittery and can move without warning, which is why so many investors gravitate toward mutual funds.
Protective collars are risky when the market seems hot, or if you think your stock will make big gains. In that case, you may lose out on a lot of money.
Protective collars are most useful for investors afraid that the bottom will drop out, or those who see limited growth potential in their investment. If that is the case, the money you make off the covered call will pay for the protective put (which otherwise could be fairly expensive on its own). Their offsetting premiums make protective collars relatively inexpensive, if you set your strike prices correctly. With protective collars, then, you will have built a position with limited upside, yes, but also with limited downsides.
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