Long-term investors often like to accumulate more shares on market dips, but sometimes a real bear market provides too much opportunity to buy shares. If you’re relatively young, the buying opportunities down markets present can come in handy. But if you’re in the later stages of your investing career, those market declines can really hurt. That’s one reason why not everyone has the same feelings when the markets head south.
One method for preserving your capital is to enter stop-loss orders. These orders are fairly easy to implement and they usually achieve the desired result: as markets decline you continue to sell, reducing the potential for future losses on your long positions. (For more on stop-loss orders, check out Nicole Wachs’ post Market, Stop and Limit Orders, as well as Brian Overby’s post Contingent vs. Stop Orders. You should also check out this disclosure of Advanced Orders risks.)
It’s good to take advantage of this protection from time to time, but it also can feel anti-intuitive. Investors like the idea of buying at lower prices, not selling into them.
What’s an investor to do: Hold, listening to the pundits who tell you that markets always go up over the long term? Or protect yourself because you need the money to be there when it’s time to buy that house, send the kids to college, or retire?
I prefer the conservative, preservation-of-capital route. To achieve that I often use collars, an options strategy that I’ll explain in more detail below. Options are useful here in that they can help you manage specific risks. Here, the specific risk is being too long in a falling market, or in Optionspeak, owning too much long delta. (For more on the Greek delta, check out Brian Overby’s series on delta, starting here.). Options are not for everyone as they carry risks that are often too complex for the average investor. For many, capital preservation may be better achieved with a regular stop loss as described above.
Here’s how you set up a collar: for each 100 shares of stock you wish to protect, you buy one put at strike price A and sell one call at strike price B. You’d usually put on this play when the stock is trading between strikes A and B, and the goal is for the stock to trade at or above strike price B. Your maximum potential loss is limited to the current stock price minus Strike A plus the cost of the collar (put premium minus call premium). For full details on this trade, including associated risks, login to your TradeKing account and go to Education > The Options Playbook, Play #8, Collars. (Commissions at TradeKing to initiate this trade are $16.15, based on the buying of 100 shares of stock, selling 1 call option, and buying 1 put option.)
(Keep in mind that multiple-leg options strategies involve additional risks and multiple commissions and may result in complex tax treatments. Consult with your tax advisor as to how taxes may affect the outcome of these strategies. We’ve simplified this imaginary projected return by not taking into account expenses like taxes; in the real world, you should factor this into your calculations.)
Back to this collar. The put acts as a hedge against potential losses; it guarantees that you can sell shares at its strike price. That’s very similar to using a stop-loss order, with an added feaure: When the stock hits your target sell price, you continue to hold the stock, plus your put option. With a stop-loss order in place, the stock will most likely get sold when your stop is triggered. (If you enter a stop-limit order, of course, two conditions have to be met before that happens: 1. your stop has to be triggered, and then 2. your limit price or better has to be met.)
If the stock reverses direction and you own the put plus stock, you will not be have sold at your stop-loss price. Instead, you get to keep the stock, and the potential loss may vanish while you were still covered. If the stock does not move higher, you can always exercise that option to sell the shares at a later time. (Exercise cost at TradeKing is $9.95 per occurrence.)
Buying a put to insure the value of your investment portfolio can get costly. One way to overcome that problem is to sell one call option. The cash from that sale is often sufficient to cover the entire cost of buying the put; that’s one of the reasons for turning the married put (stock plus put) into a collar. When that happens, you can own your trade hedge at zero out-of-pocket cost.
What’s the downside? Limited profits. You cannot sell stock above the strike price of the call. If the stock moves higher, the owner of the call option will exercise his/her rights to buy your shares at that strike.
In short, you have a choice when protecting long positions against a downtrend:
1) Enter a stop-loss order. That does not limit your upside potential and gives you the downside protection you want.
2) Buy the collar. Profits are limited and the downside is protected. But this time you get to avoid those upsetting situations in which you sell stock, only to see the market move higher.
To me it’s a comfort zone decision: which would make you feel worse? Selling a call and seeing the stock rise through the strike price? Or being stopped out of a position, only to see it rise quickly later?
I prefer to use the collar, but to each his/her own. I don’t like to sit idly by and watch the market drift lower – the ostrich strategy may be the riskiest one of all.
Regards,
Mark Wolfinger
Founder, MDW Options
TradeKing All-Star Commentator
Options involve risk and are not suitable for all investors. Please read Characteristics and Risks of Standardized Options.
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Any strategies discussed and examples using actual securities and price data are for educational and illustrative purposes only and do not imply a recommendation or solicitation to buy or sell a particular security or to engage in any particular investment strategy. In reading content in the Trader Network, you may gain ideas about when, where, and how to invest your money. Although you may discover new ideas or rationale that may be compelling, you must ultimately decide whether or not to put your own money at risk. Consider the following when making an investment decision: your financial and tax situation, your risk profile, and transaction costs.
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