Options Basics, Two Key Uses and the Benefits of Collars

Posted on Mon 8th Jun, 2009 09:30:45 PM

When some investors first learn of the existence of options, they often get excited about the money-making prospects and are anxious to begin trading. That’s often the result of hearing some ultra-hyped promotion that promises fantastic profits. Unfortunately, those profits are seldom realized, especially when the investor fails to take the time to learn about options and how to use them effectively.

On the other hand, there are those who have constantly been steered away from options because some broker once told them that options were too risky. It amazes me how many financial professionals don’t understand – or more likely don’t want to be bothered to learn from themselves – how conservative option strategies benefit their clients.

There are two basic ways to use options

To hedge: Reduce losses and minimize risk
To trade: Own equity positions without buying or selling shares

Using options to hedge

Options were invented (centuries ago) to reduce risk. Yet, too many investors find that to be an unexciting method for accumulating wealth over the years. Investing is serious business and it’s unfortunate that most people still believe that ‘buy and hold,’ is the only choice available, and have no idea how to protect their assets from bear markets.

Just as you insure your home or car, you can buy put options to insure the value of your stock market portfolio. They’re not cheap, but neither is other insurance. Put owners have the right to sell their holdings at a pre-determined price. You pay a premium, choose a deductible, and select an expiration date. In return you are protected – there is a floor, or a minimum value, for your portfolio. No matter how far the value of your stocks fall, you retain the right to sell those stocks at the agreed upon price. With auto insurance, if the car is ‘totaled,’ your insurance pays you a specified amount. With put options, if your assets are hurt (fall below the minimum value), you are paid a specified amount (the strike price) for each share of stock that you insured.

If you do collect on that insurance (exercise the puts), you can put your money back to work by buying the same stock at lower prices, or find another investment. If the market does not undergo a severe decline, then the put eventually expires – just as other insurance policies expire. With traditional insurance, most people renew their insurance annually. You can do the same.

As mentioned, this is very expensive proposition. Then why mention it? Because this idea can be modified into a conservative strategy for protecting your investments – if you are willing to accept a limit on potential profits, you can own this insurance for little, or zero cost. You do that by adopting the collar strategy.

The collar establishes a minimum value for the portfolio (same as buying put options). But if you want to get that insurance at no cost, you can do so by selling call options. You use the cash collected when selling calls to pay for the puts. What’s the catch? You must be willing to sacrifice the possibility of earning a large profit from your portfolio because the call options give someone else the right to buy your stocks – at predetermined prices, for a limited time.

Thus the collar limits losses by providing a price you are guaranteed to receive if the market tumbles, but it also establishes a maximum price you can receive for your portfolio if the market marches higher. Is this a good tradeoff? There is no correct answer because each investor must decide how much he/she is willing to give up for the knowledge that there will never again be losses such as those seen when the technology bubble burst or during the 2008-2009 market massacre.

Collars can be built to suit. In other words, if you prefer the possibility of earning significant profits on a stock market rally, you may elect to sell call options with higher strike prices. In return, you collect less cash for your calls. Because the call buyer would have the right to buy your stocks at a higher price, that option is worth less and he/she pays less. That’s okay. It’s another tradeoff. You get something (higher potential profit) and give up something (collect smaller premium).

Similarly, you can elect to pay less for your insurance policy by establishing a larger deductible. In simple terms, that means you choose to accept a lower minimum value for your stocks (lower strike price for the puts purchased).

Why doesn’t everyone know about this? Good question. There are no salespeople pushing these ‘insurance policies.’ Are you aware of the advertising campaigns for regular insurance? Ads are everywhere. Because stockbrokers don’t push the idea of using options, most individuals are unaware that this insurance exists.

Using options to invest

Options are versatile investment tools and can be used in a variety of strategies that make it unnecessary to buy or sell stock. Although it’s beyond the scope of this article, simple investments that use both puts and calls can be used to own investments that behave exactly the same as if you owned the collar strategy above. In other words, you can trade only options and still own insured positions that behave the same as collars.

Mark Wolfinger is a 20 year CBOE options veteran and is the writer for the blog Options for Rookies. He also is the author of the book, The Rookie’s Guide to Options.

Further Reading, Options Trading: