After a number of big-name stocks like Apple and Amazon hit record highs recently, many of them moved lower over the past several sessions. As an investor, this can be a little disheartening, to say the least. But if you know how to use options, some of these gains can be protected. Let’s take a quick look.

Collars

A collar is selling a call option and using some if not all of the premium collected to buy a put option. Think of it as a covered call and a protective put as one trade. Many investors will sell call options against their long stock position to potentially increase their return. But with collars, the proceeds are used to partially or fully pay for a long put. The buyer of a put option has the right to sell the stock at the strike price. So, if the stock declines, the investor has the right to sell the stock at the strike price up until expiration. Let’s look at a recent example.

Target Corp.

Let’s pretend that back in May, you bought Target Corp. (TGT) at $70. At the time of this writing, the stock was trading at $89.25. Now you think it might be a good time to protect those gains. Taking a look at the October (Oct 19th) options, you could sell the 95 calls for 0.75 and use that to buy the 85 puts for around 0.95. The cost of the collar is 0.20 (0.95 – 0.75) or $20 in real terms. The stock still has the ability to rise up to $95 by expiration before the shares will be “taken away” because of assignment. And if the stock declines, the investor has the right to sell the shares for $85 a share up until expiration, preserving most of the current gains.

The Right, Not the Obligation

Just a reminder, owning a put gives you the right to sell the shares but not the obligation to do so. So even if the stock drops below the $85 level from the example above, it does not mean you have to sell the shares. You could always sell the long put, which will have some intrinsic value if TGT is below the strike price. This is something to consider if you think this may be a temporary pullback and the stock could eventually move higher or again. Or maybe you plan on holding this investment for the long term no matter what happens, within reason. The bottom line is an option trader has options.

Last Words

As a holder of long shares, a collar should always be in consideration particularly if there has been an increase in value since taking ownership. The protection usually comes at a fair price, and it still lets the position profit even more depending on what call strike is sold.

John Kmiecik, Market Taker Mentoring