Option Investor
Educational Article

Real World Insurance

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In the past, I've written about the utility of putting on a collar position to protect gains in the underlying stock. The basic strategy consists of selling a call above the current price of the stock and using the proceeds to purchase a put. The net result is a free (or nearly free) insurance policy on the stock you own. For a detailed explanation of how such a position is structured and implemented, check out my recent article on the subject at:

Preventing Whiplash

In case you hadn't noticed, we've had another powerful rally in the past 4 weeks, and the magnitude of the rebound off the October lows has now exceeded that of the rally off the July lows. We all remember what happened after the markets topped out in late August, so prudent investors would be well served to consider putting some collars on profitable stock positions.

Rather than bore you with the tedium of another abstract example, I have a dual purpose here. Obviously my first goal is education of those of you that are seeing the concept of the collar presented for the first time, as well as remind some of you old timers that the time is ripe to acquire some cheap insurance. But my ulterior motive is purely self-serving. I want to brag a bit on behalf of myself and the other writers here at the newsletter.

By popular demand from many of you back in early September, the staff here at OI started picking stocks that we expected would perform well in a recovering market environment. This is different from our standard fare, as we were actually talking about buying the underlying stock and holding on for the eventual recovery. If you've missed our coverage of the Stock Plays, you can catch up on each of them, along with our rationale for each play at the link below.

Stock Plays

Our focus was predominantly on the cheaper, more heavily shorted stocks (but still with a solid fundamental outlook), as they should benefit the most when a real rally hit, causing the shorts to cover. Needless to say, that's what we've been watching unfold in the past few weeks, and as you can see from the list of stocks in the table below, the results in our Stock Play list are pretty good.

The column "Pos Date" indicates the date we added the play to the Stock Play list, and the "Basis" column reflects the price at which the stock was trading when we added it. Scanning over to the far right column "P/L%", you can get a feel for the performance of each of the picks, as well as the overall list. I want to focus on NVDA, which is far and away the best performer in the list, up more than 80% in about 6 weeks. Only the most bullish optimist would be looking at those stellar gains and feel comfortable just 'letting it ride'. It wouldn't be a dumb move to just lock in those profits by selling the stock, but if you're like me, you won't want to sell because of fears that you'll miss any additional upside in the stock. Or maybe you're holding the stock in a taxable account, and you would prefer to hold it long enough so that when you do sell, it can be treated as a Long-Term Capital Gain.

That's where the collar position comes into play. Simply put, the collar let's us stay in the bullish trade that is working in our favor without being exposed to the risk of giving back the bulk of the short-term gains. So let's see how this strategy can work for our NVDA play.

NVDA Daily Price Chart

The continuing strong rally in Semiconductor stocks has helped to propel NVDA above the $15 resistance level and it should now act as support. If it doesn't, then we'll know something is wrong. So we want to protect our downside in the stock by purchasing a put at the $15 strike. Since December contracts only have a little over 5 weeks of life in them, we'd prefer to go out to the January expiration, acquiring better than 2 months of protection. The JAN-03 $15 Put (UVA-MC) currently costs $2.25.

Now we need to find a call that we can sell (likely in a later expiration month) that will both pay for the put we want to buy, but also give the stock some upside room, so that possibly we won't have it called away. Looking at the chart above, the $22 level is less likely to be hit than the $20 level, but looking at the option prices, we just can't get enough premium from the $22 strike in March. And unfortunately, $20 is the highest strike price currently available for June, which is the next expiration month.

March $20 Call - $2.05 x $2.20
March $22 Call - $1.35 x $1.55

So we select the March $20 Call, which we can sell at the bid for $2.05. That still gives us upside in the stock to the $20 level before we have to be concerned about having the shares called away. And we are protected to the downside until the 3rd week in January, so that the most we can lose in the stock from Wednesday's closing price is $1.18 ($1.88 - $15.00). And all it cost us was a measly $0.20 ($2.25 - $2.05) or $20 for each 100 shares of NVDA stock that we own.

For the benefits the collar provides, I don't see how traders with an 80% paper gain in the past 6 weeks can afford to pass it up. If you're sitting on significant gains in any of our listed Stock plays, let me encourage you to give serious consideration to the strategy while those gains are still available to be protected.

Until next time, protect your profits.


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