Most Popular
1. Banking Crisis is Stocks Bull Market Buying Opportunity - Nadeem_Walayat
2.The Crypto Signal for the Precious Metals Market - P_Radomski_CFA
3. One Possible Outcome to a New World Order - Raymond_Matison
4.Nvidia Blow Off Top - Flying High like the Phoenix too Close to the Sun - Nadeem_Walayat
5. Apple AAPL Stock Trend and Earnings Analysis - Nadeem_Walayat
6.AI, Stocks, and Gold Stocks – Connected After All - P_Radomski_CFA
7.Stock Market CHEAT SHEET - - Nadeem_Walayat
8.US Debt Ceiling Crisis Smoke and Mirrors Circus - Nadeem_Walayat
9.Silver Price May Explode - Avi_Gilburt
10.More US Banks Could Collapse -- A Lot More- EWI
Last 7 days
Stock Market Volatility (VIX) - 25th Mar 24
Stock Market Investor Sentiment - 25th Mar 24
The Federal Reserve Didn't Do Anything But It Had Plenty to Say - 25th Mar 24
Stock Market Breadth - 24th Mar 24
Stock Market Margin Debt Indicator - 24th Mar 24
It’s Easy to Scream Stocks Bubble! - 24th Mar 24
Stocks: What to Make of All This Insider Selling- 24th Mar 24
Money Supply Continues To Fall, Economy Worsens – Investors Don’t Care - 24th Mar 24
Get an Edge in the Crypto Market with Order Flow - 24th Mar 24
US Presidential Election Cycle and Recessions - 18th Mar 24
US Recession Already Happened in 2022! - 18th Mar 24
AI can now remember everything you say - 18th Mar 24
Bitcoin Crypto Mania 2024 - MicroStrategy MSTR Blow off Top! - 14th Mar 24
Bitcoin Gravy Train Trend Forecast 2024 - 11th Mar 24
Gold and the Long-Term Inflation Cycle - 11th Mar 24
Fed’s Next Intertest Rate Move might not align with popular consensus - 11th Mar 24
Two Reasons The Fed Manipulates Interest Rates - 11th Mar 24
US Dollar Trend 2024 - 9th Mar 2024
The Bond Trade and Interest Rates - 9th Mar 2024
Investors Don’t Believe the Gold Rally, Still Prefer General Stocks - 9th Mar 2024
Paper Gold Vs. Real Gold: It's Important to Know the Difference - 9th Mar 2024
Stocks: What This "Record Extreme" Indicator May Be Signaling - 9th Mar 2024
My 3 Favorite Trade Setups - Elliott Wave Course - 9th Mar 2024
Bitcoin Crypto Bubble Mania! - 4th Mar 2024
US Interest Rates - When WIll the Fed Pivot - 1st Mar 2024
S&P Stock Market Real Earnings Yield - 29th Feb 2024
US Unemployment is a Fake Statistic - 29th Feb 2024
U.S. financial market’s “Weimar phase” impact to your fiat and digital assets - 29th Feb 2024
What a Breakdown in Silver Mining Stocks! What an Opportunity! - 29th Feb 2024
Why AI will Soon become SA - Synthetic Intelligence - The Machine Learning Megatrend - 29th Feb 2024
Keep Calm and Carry on Buying Quantum AI Tech Stocks - 19th Feb 24

Market Oracle FREE Newsletter

How to Protect your Wealth by Investing in AI Tech Stocks

Investing in Stocks - Safety in Numbers, Protection in Options

InvestorEducation / Learning to Invest Feb 19, 2015 - 07:00 PM GMT

By: Casey_Research

InvestorEducation

By Andrey Dashkov

If you want to fail as an investor, the possibilities are endless. Buying stocks on a whim, holding on to the losers for too long, and dumping winners too soon are just a few ways to start.

Options, like anything else, can cost you money or make you money. Due to the leverage employed when trading options, they often add both a layer of potential profit and a layer of risk on top of their underlying assets. But a less-known benefit of trading options is that they can serve as a hedge or form of insurance.


To illustrate, I’ll use a strategy that may seem intimidating but shouldn’t be: option collars.

Even though it sounds technical, it’s actually pretty simple. It boils down to holding an underlying asset (let’s say shares of a stock) while simultaneously selling (i.e., writing) call options and buying put options on that holding. The premium received from selling the call covers (completely or mostly) the premium paid to buy the puts, and the two of them work together to limit portfolio risk.

Let’s take a look at how a collar works step by step.

Suppose stock XYZ is trading at $40 a share on January 1. You want to invest in the stock, but you’re worried that the market could tank within the next couple of months and take XYZ down with it. So you decide to set up a collar to limit your downside risk.

You decide March 20 (more on the date in a moment) is far enough into the future to protect you from the imminent market decline you’re worried about. You also decide that if you could sell XYZ for $50 between now and March 20, you’d be happy with that gain; but you don’t want to have to sell XYZ for any less than $30 over that time period.

So, to create a collar that meets all of your requirements, you do three things: buy 100 shares of XYZ at $40; sell one March call option on XYZ with a strike price of $50; and buy one March put option with a strike price of $30.

(Please note that the third Friday of the contract month is the option expiration date. That’s why we used March 20 above. Also, each options contract is written on 100 shares of the underlying asset. That’s why we only need to sell one call option contract and buy one put option contract on XYZ to collar our 100 shares.)

Now, back to creating the collar…

Let’s assume that the premium you receive from selling the March call option is $1 per share (i.e., $100 per contract), while buying the March put option will cost you $0.50 per share ($50 per contract).

So your initial outlay is $4,000 for the 100 shares of XYZ and $50 for the put; and you receive $100 from writing the call. Your total investment is $3,950. (We’re ignoring broker commissions throughout this illustration.)

Now let’s consider two scenarios:

  1. Before March 20, XYZ goes up to $55. In this case, your call option is exercised at $50, and you’re forced to sell your shares at that price. That’s fine, because you had already decided that you were willing to sell your shares for $50 within that time period. Your proceeds are $5,000, and the net gain is $1,050, or 26.6%. Not bad! The trade-off, however, is that the gain is limited: if the stock shoots to $80, you still have to sell it for that $50 strike price.
  2. Before March 20, the stock goes down to $25. Without the put protection, you’d incur a loss of $15 per share (approximately 38%), or $1,500 for the whole position. But that’s not what happens: your protective put allows you to sell the shares for $30 each, establishing a floor for your losses. So you sell the shares for $3,000 and pocket a loss of $950, or 24.1%. Even if XYZ had gone to $0, your maximum loss would still only be 24%.

The payoff would look like this.

So while options are a powerful tool that can ruin an investor who doesn’t understand them, here you see how they can be used as protection. Remember, however, that unless you’re a seasoned options trader, it’s wise to leave even protective strategies to the professionals. In fact, the Money Forever team only recommends one options strategy for individual investors: selling covered calls. Learn more about this straightforward, low-risk moneymaker and download our free option calculator here.

The article Safety in Numbers, Protection in Options was originally published at millersmoney.com.
Casey Research Archive

© 2005-2022 http://www.MarketOracle.co.uk - The Market Oracle is a FREE Daily Financial Markets Analysis & Forecasting online publication.


Post Comment

Only logged in users are allowed to post comments. Register/ Log in