Opinion: Put a “collar” on your stocks to protect yourself from a market correction

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The S&P 500 SPX,
-0.03%
is within 3% of a record set in early September, and with the benchmark doubling since its pandemic low in February 2020, the risk of a correction is increasing.

Some investors wonder what steps they can take to protect their positions and portfolios, without trying to time the market by selling before it goes down and buying before the recovery is in full swing.

There are ways for investors to hedge their positions and protect their profits. The term “blanket” dates back to medieval times when homeowners planted hedges around their homes like a fence for protection.

Most investors should stay invested for the long term and overcome periods of inevitable market volatility. If they try to time the market, they tend to come back to the market too late, which erodes long-term returns.

At some point we will experience another economic recession, which is usually accompanied by bear markets. The terms “bull” and “bear” markets date back to early California history when they organized fights between the two beasts. The bulls were hitting with their horns while the grizzly bears rose and fell with their paws, so bull markets go up and bear markets go down.

To protect yourself

One way to protect positions is to use options. First, the definitions:

a option is a derivative security that allows the buyer to buy or sell a security at a particular price within a specified time frame. This price is known as the strike price.

A call option allows the buyer to buy, while a put option allows the buyer to sell.

A stock ex-dividend date is the date it trades without including the value of its next dividend. All other things being equal, a share’s price will drop by the amount of the next dividend on the ex-dividend date. If you own a share before the ex-dividend date, you will receive the next dividend. If you buy it on the ex-dividend date, the seller will receive the next dividend.

Options are not suitable for all investors. A common options strategy is known as necklace. To put on a necklace, you sell a call option and use the funds received from the sale of the call option to purchase a put option. This is called a collar because you limit your upside potential by selling the call and your downside by buying the put.

When you write a call option, you are obligated to deliver your shares or shares of an exchange-traded fund at the strike price before the expiration date if the underlying security is above that price. (In industry parlance, your position is “called” or “recalled.”) If you buy a put option, you have the right, but not the obligation, to sell your holdings at the strike price at expiration date.

Typically, necklaces are set up for credit, meaning you receive money to establish the position and keep that premium if the underlying stock stays between the two strike prices. You can also set them cost neutral or for a debit – it all depends on what strike prices you choose to limit the rise and fall.

When you select the expiration date, you can determine how long the collar will stay in place. Some investors like to restrict their holdings around earnings reports or other economic news or events that can drive stock prices up or down. Options can be useful tools, but they also require sophistication, and the risks and rewards need to be fully understood.

Necklace example

Suppose you bought 100 shares of AbbVie Inc. ABBV,
+ 0.04%
September 17 for $ 107.40.

You could have sold a call option expiring on November 19 with an exercise price of $ 115 for $ 1.12 per contract. This is called a covered call option because you already own the stock. If the stock price exceeds $ 115 by November 19, you will likely be forced to sell at $ 115. Your profit will be $ 7.60 per share, plus you keep the $ 1.12 share premium that you earned when selling the option. If the stock price has not risen enough for the option to be exercised (for your stock to be called) by November 19, you keep your premium of $ 1.12 and are free to sell one. other option.

For a necklace, you would have bought a put option expiring the same day, for 80 cents per share.

AbbVie’s quarterly dividend is $ 1.30 per share. The ex-dividend date is October 14, the payment date is November 15, and the stock’s annual dividend yield, based on the price of $ 107.40 you paid on September 17, is 4, 84%.

To set this necklace – which in the industry would be called a November 115 X 90 necklace – you get a credit of $ 0.32, or $ 32 (one hundred times 32 cents). So you sold a November call option at $ 115 for $ 112 and bought a November put option at $ 90 for $ 80. The difference between the $ 112 credit and the $ 80 debit is a $ 32 credit, which you keep. (For this example, commissions were not taken into account.)

If your stock is redeemed, your maximum gain is $ 9.22 or $ 922 in 63 days, or a return of 8.5% during that time.

Your maximum loss with the 90 puts would be $ 15.78, or $ 1,578, or 14.7% in 63 days.

Kenneth Roberts is a registered investment advisor based in Truckee, California.


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