So you were one of the prescient few that bought LEAPS or shares on your favorite index, stock or HOLDR in early April and you are sitting on nice fat profits right now. I know exactly what is going through your mind. "Well, that's a nice profit, but I don't want to give it back to the market. So maybe I should sell and take my profit. But I think there could be some more upside, and I'm not quite ready to close the position. But I don't want to be greedy and end up giving my profits back to Mr. Market." And the debate rages on...
What if there was a solution that would allow you to have your cake and eat it too. Translation: stay in the long position, but remove the risk of evaporating profits. This is your lucky day, Sparky, because we've got just the strategy you're looking for. It's called a Collar, and the simplicity is almost poetic.
Here's the basic strategy. You have a long position (let's assume for the sake of discussion that you bought shares of the QQQ in early April at $37), and you want to insure against a possible drop in price, which could wipe out your gains in a hurry. So, figure out how much of a loss you are willing to accept, and buy a protective put at that level. If the QQQ falls below that level, we will make money on the protective put at the same rate that we are losing it on the long shares, meaning that our loss on the long position stops as soon as the price drops below $45. The QQQ can go all the way to zero, but we only lose $2.48 on the position (Current price = $47.48 - $45 strike). But that costs money, cutting into your paper profits. So let's sell a higher call, to finance the purchase of the put.
Effectively what we are doing is turning the long position into a covered call and using the proceeds from the covered call to finance the purchase of a protective put. Sounds great, huh? The best part is that due to differing timeframes and our associated expectations, we can create all sorts of different scenarios, tailored to meet our needs.
I think the best way to demonstrate the concept is through examples, so let's go. Start with 1000 shares of the QQQ with a cost basis of $37. The QQQ is now trading at $47.48, giving us a paper profit of $10,480. We are concerned about near-term weakness causing the price to drop below $40. We don't want to incur a loss below the $45 level, so we will buy protective puts at the $45 strike price. Since June is almost over, let's buy July puts to protect our position for the next 5 weeks, well into earnings season. The July $45 Put (Symbol: QQQ-SS) is currently selling for $2.00, making our net insurance cost $2000 (10x$200).
Now we need to pick a call to sell that will allow us some upside in our underlying QQQ shares, but one that has enough premium to offset the cost of the puts we want to buy. There seems to be significant resistance waiting overhead in the $54-55 area, so let's sell strikes in that area to minimize our chances of getting called out of our shares. The July $54 calls are a little too cheap to get my attention, so now I need to make a decision. I can either sell a lower strike, limiting the upside of my long position in the event that my fears are ungrounded, or I can sell the call with a longer timeframe.
Selling a longer term call is the approach that appeals to me, because it gives me more potential upside on the play. So I decide to sell the September $54 calls for $2.25 each, bringing in a total of $2250.
So let's review. I own 1000 QQQ shares with a cost basis of $37000, and a current profit of $10,480. Selling the SEP-54 calls brings in $2250, and buying the JUL-45 puts costs $2000. Adding it all up, gives me a hedged, profitable position with $2230 (2480-250) of downside risk and $6770 of upside potential. That's a reward-to-risk ratio of 3 to 1; a situation that will definitely allow me to sleep at night!
Just in case the math isn't clear, let's run through some possible outcomes, so you can check my math.
Case #1: The bottom falls out of the Tech sector, and the QQQ craters, falling back to $35 at July expiration. The long position has lost all of its profits,...and then some! What originally cost me $37,000, is now only worth $35,000. I gave up over $10,000 of profits and then lost another $2000 from there. So from the time of initiating the trade, my long position lost $12,480...OUCH! Aahhh, but don't forget about that little insurance policy. Those 10 $45 strike puts (that cost us nothing because of the covered calls we sold) are now $10 in the money, meaning each of them are worth a cool grand. Total profit on the puts is $10,000. The calls are so far out of the money now that they are next to worthless, and we could likely buy the whole lot back for about $100. So the worst thing we could imagine came to pass and our loss is limited to $2330, or 4.9% of the position value when we initiated the collar. Here's the math:
Cost Basis = $37,000(QQQ shares)+$2000(Puts)-$2250(Calls) = $36,750 Expiration Value = $35,000(QQQ shares)+$10,000(Puts)-$100(Calls) = $44,900
That leaves us with a total profit of $44,900-36,750 or $8150. The best part is that we still own the QQQ shares, and unless the NASDAQ looks like it is headed much lower, we are set to enjoy another nice and profitable rally.
Case #2: Every Tech company under the sun announces blowout earnings and the NASDAQ goes vertical, rocketing the QQQ up to $75 at July expiration. Needless to say, our puts will expire worthless, and we are in a position to pocket a portion of the gains from our long position. The QQQ shares are worth $75,000 now, but it will cost us $21 to buy back each of those covered calls. They are so deep in the money that all the value is now intrinsic...no time value. So if we buy back the calls, it will cost us $21,000, leaving us with a profit on the long position of $17,250 (75,000-21,000-36,750). That's a profit increase of $6770 for an additional 5 weeks in the trade. Seems to me like the collar was a good idea.
Case #3: Finally, the most likely scenario. The NASDAQ continues to waffle in its current range, coming to rest at July expiration at the $51 level. Our puts expire worthless and we are left with a nice little covered call position. We could then evaluate the current market condition and decide what to do next. By now we are well into earnings season, and if things are starting to look healthier, I might just hold the position through September expiration. Ideally the QQQ would end at $53.99 and I wouldn't be called out of my shares. If they closed above that level, I would likely be called out, ending the play and locking in my profits. If the current cycle of earnings was looking weak and Greenspan had halted his string of interest rate cuts, I might decide to just close out the play early, buying back the calls and selling the shares, also locking in my profits. Either way, the collar served its purpose, allowing me to stay in the position a little longer without putting all my profits at risk.
There are innumerable variations to this strategy. While we didn't cover half the possibilities, hopefully this little discussion gives you a glimpse of how combining options can allow you to obtain a free insurance policy, giving yourself a little more staying power in an uncertain market.
Until next time, protect your profits.