Sunday, January 5, 2014

How to protect your profits using collared options

In the previous post on protecting profits we discusses selling call options to force you to take profits rather than getting carried away by greed in the last stage of a bull market. Selling a call option in fact, limits your upside (a bit), because after the underlying share price exceeds the call option’s strike price you as writer of the option are obliged to sell your shares at that strike price; this caps or limits your upside.

Of course, with today’s low discount brokerage commissions it doesn’t take much to repurchase the assigned (and sold) shares for around the same price or, upon a small market pull back repurchase the shares at a slightly lower price. When doing so you once again may write new call options against the repurchased price - often with a slightly higher strike price. As long as the market keeps on going up there is no problem. But the higher the market goes… the closer the crash and the higher the risk of not being able to bail out and likely holding your shares all the way to the next bear market bottom.  For a buy and hold investor with lots of patience, that may not really pose a problem. But it robs you of cash to buy great companies for dirt cheap prices near the upcoming bear market bottom.  That is what this is all about: building cash for the next crash!
The emergency break – the price stop set at 25% below the last market high or your most recent purchase price (whichever is higher) may still protect you and provides still a bail out well off the next bear bottom but that is still  a 25% drop! So if we sell call options forces us to sell near a market peak is there a way to reduce the downside better than a 25% loss from the last peak?
Yes! We can collar our profit by limiting both upside AND downside.  Instead of pocketing the call option premium, we use the premium proceeds to BUY a put option over the same term as the call option; say 3 months. Buying a put option means that we are buying insurance against a precipitous drop in the price of the underlying shares. A put option is the right to sell a share at a certain price (the strike price) over a certain period of time. Say we collected $150 dollars for selling a call option on 100 TD shares. Now we are using the proceeds to BUY put options for those same 100 TD shares. By owning the put option, we have the right to sell the TD shares at the strike price and thus, we can bail out with no or a limited loss at any market price that TD may have fallen to – possibly far below the strike price of the option during the term of the option. Thus our ‘loss’  is only equal to the difference between the share price at market peak and the strike price of the put option with may be a lot less than the 25% price drop of the stop-loss.
Let’s do an example:      
TD shares are trading at $100 in January. We own 200 shares worth $20,000.  We write a call option with a strike price of 2.5% above the $100 expiring on April 19, 2014 and collect a $200 premium.  We have already a stop loss price for 25% below TD’s latest high of $100); i.e. sell trigger at $75.00 per share. But that is still quite a price drop. What if we could sell at $90 dollars? Wouldn’t that be better?  So, we’re using the proceeds of the call options sale to buy insurance in the form of 200 put options with a strike price of $90 that expires also on April 19, 2014. Since a 10% drop in share price is often less likely than a 2.5% share price increase, the premium of the put option is probably somewhat less than that of the call option we sold. Say the premium is $150 and we still pocket $50 profit on the option trade as a result. There are three scenarios that could happen:
Scenario 1: During the next three months share prices of TD go over $102.50 and TD gets ‘called’. Result, you make an additional $2.5 profit above the $100 price in January (200x2.5 = $500) plus you will likely collect a dividend of around $0.68 cents per share or 200x 0.68 = $136.00. Your put options expire worthless and you collect $200 minus $150 = $50 in option trade profit. A nice return for just 3 months!
Scenario 2: During the next three months share prices of TD do not exceed $102.50 and do not fall below $90. You collect $136.00 in dividend and a $50 option profit. Plus you keep the shares for another day of course. Not much gain but certainly no pain!
Scenario 3: The market goes haywire and TD shares fell to $85 dollars.  You exercise your put option right prior to expiry. Collect $136.00 in dividend; collect $50 in option premium profits and sold at $90, losing $10 dollar from the peak of the market at $100. Thus you still made more than if you sold at the $85 share price at the time of the option expiry. If this was only a correction and at $80  the market turns up again, you can repurchase the TD shares for anywhere between $80 and $85 dollars and be better off than before. If the crash continuous all the way to a bear market bottom typically 50% below the bull market peak, then you’re laughing with cash in your hand ready to buy around the bear’s bottom. Mission accomplished!
You have collared both your upside and your downside and it didn’t cost you a penny. This is a great technique in top-heavy markets – but you have to be on top of things so that can react according to the 3 scenarios.
Just some words of caution: option trading is something you have to learn in tiny steps. I have been trading this stuff now for over 5 years and got only more active over the last 3 years or so. My trades are still small – 2 to 4 contracts at a time. So yes, percentage-wise the profits are huge but the impact on my overall portfolio is still small. Also, check out my post: Outlook 2014 and you see that I am far from bearish. In fact, many market guru predictions are cautious and the market itself, except for some outliers such as Facebook or Twitter, is reasonably priced. I think there is still a lot of room for upside – we’re at ‘the beginning of the last inning’. The last inning may last another year or another two years or… it may be tomorrow! Who knows the future?  I do not longer recommend buying large amounts of stocks nor do I recommend to start selling off the portfolio in a panic. Rather, I suggest looking for clouds appearing at the horizon and start preparing for the coming storm whenever that may happen. ‘Be Prepared’ is the Scout’s motto and so should we.

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