Protect Your Stocks Using Put Options - The Collar Strategy
Hoping and praying that the stocks that you just bought will go up is not the best strategy to use, however it is the one very often used by the average Joe stock trader. The only salvation they have is that in bull markets most stocks will go up.
In fact when the market goes up about 70% of stocks will also go up and in the same way when the market goes down it will also take about 70% down with it. This is what is called trading with the trend, you can see that 75 out of 100 stocks follow the market direction so by following the trend you statistically have a much better chance of making money.
However many people own stocks that they don't want to sell for various reasons, either tax or sentimental, so what can they do if the market appears to becoming a bear market?. Stock options can provide a number of different solutions, the most popular are called the Covered Call and the mostly unknown one called the Married Put. These use Call and Put options.
Option trading can be very confusing and difficult at 1st, actually it's not that complicated once you have had a good education in the subject. However if terms like Put and Call Option, Married Put and Covered Call don't mean anything to you, don't attempt to trade options until you get that essential education in the theory.
Call options are bought and sold in 100 share blocks, this is 1 option contract. When doing a covered call you sell 1 call option contract for every 100 shares that you own. The value of the call option will go down if the stock goes down, giving you the chance to either let it expire worthless or buy it back at a much cheaper price. Either way you can get about 4-6% downside protection, but if the stock decreases more than this then you will have to take a loss.
Stocks in a bear market, and even in a bull market, can drop quickly on news or earnings releases, as much as 15 to 40% within a month. Using covered calls to protect your stocks will only provide limited protection of less than 7% at best and so will not save you if the stock takes a 40% tumble.
There is a much better way to protect stocks in a bear market than using covered calls, it is called the Married Put. Instead of selling a low credit call option we buy a Put option which can provide a large amount of downside protection. The Put can rapidly increase it's value as the stock goes down, by how much depends on how carefully the Put option has been selected. The Put is matched to the stock like a good marriage for the best results.
It is beyond the scope of this article to explain exactly which Put option to buy but the following parameters need to be considered:
1. What strike price is selected for the Put option
2. The price of the stock
3. Whether to use in the money of out of the money options
4. Put expiration time
Remember that options are a wasting asset, unlike stocks, so you need to consider the decay factor in the Puts that you have bought. Despite this the Married Put strategy is much better than the covered call because it can provide up to 90% loss protection in the event of a big stock drop.
The downside of the good protection is that you have buy the Put which is a debit whereas the covered call is a credit. But there are ways of offsetting this expense and there is much more to this strategy when executed correctly. The Married Put can be made to pay for itself and used to generate very good gains if the market, or stock to be specific, moves a lot.
The general idea of the Collar Trade is to combine the covered call and married Put strategy into one, this is what is called the Collar Trade. In effect you put a collar around the stock, sell a call and buy a PUT. If you do this correctly most of the cost of the Put can be offset by the credit from the covered call so you can protect your valuable stock at almost no cost. Yes this is a great strategy which the general public is unfortunately very ignorant of, and most brokers don't understand.
Article Source: http://www.search-raven.com
About the Author
James J. Dehoiver is an expert options investor, he also loves to learn stock trading systems and master the top technical indicators for options investors.
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by: JamesJ.Dehoiver
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