The movies tend to portray the stock market as a get-rich-quick casino where millions of dollars are gained and lost every minute. While that type of mega dollar swings does happen, the parties involved in such mega trades are entities like hedge funds that on purpose seek high risk.
For the regular folk, the stock market should be viewed as a place where money can be invested and grown into more money over time. An investor is often better off by taking measured risks and limiting his or her downside exposure than taking wild swings for the fences in pursuit of huge gains over a short period of time.
To be clear, if you can afford to lose the money you are risking, there’s nothing wrong with taking big risks. After all, one very successful trade could very well net you more gain than one year’s worth (or more) of gains from conservative trades. On the other side of the coin, one disastrous losing trade could also wipe out most—or even all—of previous gains. But again, it depends on your financial situation and whether you can afford to take big risks.
Hedging Using Options
For people who are more risk-adverse, it makes sense to hedge one’s bets. One way to do this is through the use of options.
Those who aren’t familiar with options may think of them as risky trading instruments. Indeed, if used recklessly, trading options certainly could be risky. However, the flexibility of options allows you to significantly reduce risk and narrow the range of your outcome at a low cost, or even a small profit.
One such example is a strategy called the protective collar. This strategy is used to set a floor to limit potential downside. At the same time, it also sets a ceiling on potential upside, thus creating the “collar.”
Example Using AMD
Say you have 100 shares of AMD (NSDQ: AMD), which you bought at $130. You have nice unrealized gains on the position. You don’t want to sell the stock, but you are also worried tech stocks could undergo a significant correction.
One way to protect on the downside would be to buy a put, which gives you the right to sell 100 shares of AMD at the strike price on or before the expiration date.
You buy a June 150 put for $6.10. It costs you $610 plus the negligible commission (which I will ignore for this discussion). This guarantees that even if AMD falls far below $150 by June 21 (expiration), you will be able to sell it at $150. If AMD doesn’t fall below that strike price, then the put just expires worthless.
Offsetting the Cost of Protection
The problem with buying the put is that the protection costs you $610. To offset that cost, you can sell a call against your AMD holding. The long put plus short call is the protective collar.
If you write the June 185 call for $8.30, you end up receiving an $830 premium. Since you paid $610 for the put, you actually end up with a net credit of $220. If both options expire worthless—i.e., AMD is between $150 and $185 at option expiration, you will end up with that $220 profit on the two option trades and you still have your AMD shares.
The chart below shows your gain and loss from the trade. As noted, the put sets a floor for maximum potential loss because you can always sell AMD at $150 even if it crashed to, let’s say $90. Thus, you guarantee yourself a profit of no less than $2,220. The calculation is: (put strike price – AMD cost per share) x 100 + credit from the collar trade, or in numbers, ($150 – $130) x 100 + $220.
If AMD exceeds $180, then your gain would be capped at $5,220. The calculation is: (call strike price – AMD cost per share) x 100 + credit from the collar trade. ($180 – $130) x 100 + $220. Even if AMD went to, say, $200, you’d still have to sell at $185 unless you close your short position prior to the expiration date.
Price Ending in the Middle
If AMD ends up between $150 and $180, both options expire, and your gain or loss would be the unrealized gain on your AMD shares plus the $220 profit on the collar. The gain is unrealized because you still have all your shares. Let’s say AMD ended up at $170 on expiration date, then you would have an unrealized gain of ($170 – $130) x 100 = $4,000 on AMD. Add the $220 and you get $4,220.
And of course, you can close one or both legs of the collar at any time before expiration, so if skillfully done, you can end up with more profits than shown in the chart. If you time the trades poorly, however, you can also end up doing worse than indicated in the chart.
To sum up, the protective collar allows you to protect against a catastrophic stock decline at a reduced cost, and can even end up with a modest income if the short call premium is higher than the premium you pay for the long put.
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