Afraid Of A Market Downturn? Here's Your New No-Cost Protection Play...

One of the most frequent questions I get from friends, family & colleagues - how am I preparing for the next bear market?

It seems to be on everyone's mind these days. It's understandable, as there are plenty of things to cause the fear - U.S.-China trade relations, current impeachment drama in Washington, the recent yield curve inversion, etc, etc.

But what strikes me the most isn’t the worry itself, it's how adamant people are that a bear market is definitely going to happen.

Why are they so sure?

The fact is, people are scared. No one wants to live through another 2008-09 meltdown.

Great Recession 2.0? No thanks.

Being a long-time options trading professional, it’s my goal and ambition for this blog to help enlighten you to alternative and profitable option trading strategies, ones that have brought me success throughout my almost 30-year investing career.

Many times in this blog I’ve discussed my two favorite options strategies - selling put options and buying deep-in-the-money (DITM) call options.

These are two fantastic ways to take your investing game to the next level.

But today, I’ll highlight an option trading strategy that can be used to offset downside risk for your bullish stock position, while still maintaining upside potential. And, it can all be done for zero cost. Bonus!

This is just the type of play that can help ease your mind in times of uncertainty.

Downside Protection With Upside Potential

This unique strategy combines two option contracts in one - it’s called a “collar.”

The collar is a great way to protect your downside while leaving room for capital appreciation on the upside. It's a great complement to last week's blog post which also used two option contracts to capitalize on a no-cost bullish position.

The collar is a combination of a “covered call” and a “protective put.”

Maybe some of you have heard of these strategies. For those that haven’t, here’s a quick rundown:

1. Buying a protective put option contract offers the opportunity to sell your stock at a price of your choosing for a specified period, regardless of where the stock may be trading at the time.

2. For instance, let’s say you bought a stock a few years ago for $50 per share and it’s now at $100 per share. You want to protect part of your gains, so you decide that $75 is the point where you’d bail out if the stock drops.

3. To do that, you would buy a $75 strike put option contract for its going rate (the premium). This allows you to sell the stock for $75 per share at any time before expiration, even if the stock happens to be at $40 at the time (or lower). It offers peace of mind knowing that you’re protected, even if the stock goes to zero.

4. By contrast, you could place a stop-loss order with your broker to sell the shares at $75 if the stock falls to that level. But what happens if there’s a fast-moving catastrophe, and the stock blasts through your stop level before anyone can do anything? You may get filled at $50 for all you know. Buying the protective put option guarantees you a sale price at $75.

5. You’ll have to pay for the option at its going rate (the premium), though. Let’s say it costs $3.00 per contract. This is a cash outlay of $300 ($3.00 per contract x 100 share option multiplier). This covers you for every 100 shares of stock you own. If you have 500 shares, you can choose to buy five put option contracts. This would cost $1,500.

6. If the stock falls to $50 at expiration, you still get to sell your shares for $75, but you must subtract out the $3.00 cost of the option, making $72 per share your effective exit point.

If the stock never breaches $75 before the option expires, you forfeit your $300 per contract. However, your stock holdings remain intact. You can opt to buy another round of protective puts if you desire. In essence, it's like buying insurance on your stock.

Now, let’s break down the “covered call.”

1. For every 100 shares of stock you own, you can choose to sell a call option with a strike price commensurate with the price at which you’d like to cash out.

2. For the shares you bought at $50 apiece, you’ve decided that $120 is the highest they’ll go.

3. You can sell a call option for the $120 strike price and collect the going rate. Let’s say that’s also $3.00 per contract. In this case, you’d collect $300 for each call option you sell. If you have 500 shares, you can sell five call options and collect $1,500.

4. If the stock moves above $120 by expiration, you’ll be obligated to sell your shares at $120. Even if it moves to $140 per share, you still have to sell them at $120 each. This will lock in a gain of $70 per share from your initial $50 buy price. If the stock doesn’t move above $120 by expiration, your obligation will disappear and you'll retain your long shares. You can then sell another round of covered calls and collect another round of cash.

5. This is a great way to add a new source of income to your portfolio. Your stock positions become an income-generating machine.

6. A word of caution: choose a sell point that you’d be comfortable unloading your shares, as the stock could conceivably rally higher after you cash out.

Putting It All Together

Combining the protective put and the covered call effectively “collars” your long stock positions on the upside and downside.

It gives you an automatic out on either end that you’ve set ahead of time and at comfortable price points.

In this example, the purchase price of the put option and the sale price of the call option are the same, which gives you neither a debit or a credit. This is a “no-money” way to protect yourself against downside and still allow for further upside.

As long as you create collars for no money (or even better, for a credit, which means the premiums you collect on your call options outweigh the upfront cost on the put options), you can conceivably keep the strategy going for years on end, until one side gives way.

Although a double option strategy might sound a little tedious, it’s actually quite simple to execute. You don't need to execute two separate transactions, as trades like this can be combined into a single collar transaction. Most option brokers have this capability.

So, if you’re worried about a pending downturn, or think that stocks have gotten overbought, this unique strategy can give you a no-cost way to control the downside and leave breathing room for more upside gains.

That's solid!

Until next time...

- Lee

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