In the last article Option Basics - Position Size, we discussed how to properly size your trades to avoid wiping out your account when one or more losing trades occur. In this article, we will discuss how to protect an asset in your portfolio.
First, you should understand that protection should be considered an insurance policy; and like any policy, it has a cost. The general guideline is that the cost of the insurance policy should be around 1% of the cost of the asset being protected (or less).
If you have a small portfolio of just a few equities, or if you just want to protect specific assets against a large downside move (as occurs with earnings), then an appropriate form of protection is called the collar.
The collar consists of selling a Call ATM (or OTM) while concurrently buying a Put OTM with options available for the underlying asset.
With this approach (often called a covered call with a protective Put) you are straddling the underlying asset with options that provide downside protection.
It is not necessary that both options are in the same chain (they could have differing expiration dates). The selection of expiration for the Put option will be based on how long you wish to have downside protection. The Call option is generally of shorter duration, and used primarily for reducing the cost of the Put option.
The strike of the Put option is determined by how quickly you want protection to kick-in. The further OTM, the lower the protection and the less costly the option.
The strike of the Call option will be determined by where you wish to cap the rise of the underlying asset and the premium received that offsets the cost of the long Put.
Let's look at an example.
On June 12th, we see weakness in XYZ which is currently at $423.18. We previously purchased 100 shares of XYZ earlier. To avoid a further potential drop in value, we decide to collar the stock.
We see from the charts that a potential support area from late April at 385 looks like a likely target. We also see from the charts that a possible resistance area formed at 457 during the beginning of June. Our expectation is that the down move will occur within two months.
We decide the following on June 12th: buy 1 Put AUG13 410 @ $12.33 ($1,233 per contract) with 65 days till expiration, and concurrently sell 1 Call JUL13 450 @ 7.13 ($713 per contract) with 37 days till expiration, for a total cost of $5.20 ($520 per collar, or 1.2% of the current value of XYZ).
By June 27th, XYZ dropped to a low of $394. Without the collar, the loss would be approximately $29 per share ($423 - $394), or $2,900 (100 shares). However, the collar brought in $2,312 reducing the loss to $588 (around 20% of the unprotected loss).
At this point we could either close the position down and take the small loss, or elect to hold XYZ and replace the JUL13 Call (when it expires worthless) with an AUG13 Call for more premium at the same strike or lower.
In conclusion, whenever we wish to protect an underlying asset in our portfolio, the collar is an excellent and inexpensive strategy using a Long Put option with a Short Call option.