Options are commonly used by both financial instititions and individuals for risk management strategies.
If you’re wondering how to protect stock positions with options, buying protective stock puts, buying ETF puts, selling call options and using option collars are the most commonly used downside protection strategies.
How to Protect Stock Gains
Puts go up when stocks go down, making protective puts an ideal strategy to protect individual stock gains. This is done by simply purchasing a put for the stock that you own.
Some investors turn to shorting stocks to offset rising stock prices.
Using protective puts is less risky than shorting stocks since your maximum loss is the amount you paid for the puts while shorting stocks has unlimited risk.
Buying Puts for Downside Protection
It sounds easy enough, but you’ll notice there are hundreds of puts to choose from on most actively traded stocks on your broker’s trading platform. Which protective put do you buy?
The answer depends on how much protection you want. In this example, let’s assume you’ve recently bought the stock so the market value is near your cost.
If you want to protect a stock from a large drop, then you could buy a put with a strike price that’s way below your cost, or market value in this case. While this put won’t provide as much protection as a put with a strike near the market value, it will cost a lot less than a put with a strike price near market value.
If you want more protection, you can buy a put with a strike price closer to the value at which you bought the stock. Again, this is assuming your cost is near the market value; you are buying the put when you buy the stock.
The closer the strike price is to the market price, the more owning the put option lowers your risk.
Logically, the higher the strike price on the put option, the more the put option costs.
In other words, the better the insurance, the more it cost you.
How Does a Put Protect a Stock?
Here’s how the put option lowers stock risk: Since a put option gives the buyer the right, but not the obligation, to sell a security at a set price, you’ll be able to exercise the option to sell your stocks at the put’s strike price on or before (for options in the U.S.) a given date.
Note that exercise date rules vary slightly between European options and U.S. options. For example, European options can’t be exercised early, but American options can be exercised early.
Protective Put Time Decay Warning
While a protective put strategy sounds easy, options decrease in value simply due to time passage. This means that you are buying an asset that is almost certainly going to decrease in value while you own it unless the value of your stock goes down.
This can make protective puts a dangerous strategy during bull markets.
Bull markets last longer than investors expect they will. For example, the bull market that began in 2009 lasted over 10 years.
If an investor had begun buying protective puts 6 years into the bull market in 2015, for example, he could have seen his options become worthless from time decay unless he took corrective action.
How to Use Protective Puts With Less Risk
Market cycles can be hard to time. Many investors using puts to protect stock portfolios roll the put options forward to offset at least some of the time decay since time decay accelerates as an option’s expiration date nears.
Protective puts can be rolled forward multiple times during a bull market cycle in stocks. This is what many investors and financial institutions do.
Purchasing an ETF Put to Protect a Stock Portfolio
Let’s say you own a diversified portfolio of a dozen individual stocks that tend to move in together. It can be a lot of work to buy and manage a dozen or more individual stock puts.
Instead, you can purchase a put on an ETF to provide overall protection for a diversified stock portfolio.
This strategy works the same as the strategy described above, but instead of buying puts for each stock owned, ETF puts are purchased to protect shares in many different companies against an overall market drop.
Using Calls Options to Protect Stocks
Some investors use call options to lower stock risk.
When a call option is sold “against” a stock position, it reduces stock risk by lowering the basis, or cost, of the stock position each time a call option is sold.
For example, if you bought a stock for $50, and sold a $1.00 call option against it, your basis in the overall position would theoretically be $49.
As you can see, covered calls only lower stock risk slightly.
Let’s say the call option was out of the money, however, and it didn’t get exercised. This allows you to sell more call options at $1 each in a following month. At this point, your stock cost would theoretically be $48.
Call options can be sold repeatedly, lowing the risk of owning the stock each time calls are sold by simply reducing the stocks basis, or cost.
This strategy is referred to as covered call writing.
Covered Call Risk
Since the call option gives the buyer the right to purchase your stock at the strike price, the risk is that the stock can be “called away” at a price you don’t want to sell it for. If this situation occurs, fortunately, there are some strategies you can use that will allow you to keep the stock, such as rolling the call option.
While covered calls do offer minimal risk management from owning stocks, the real beauty of selling calls against a stock position is that it can generate income in the .5 to 3% or more range per month, or up to 30% annually. More commonly, though, 1 to 2% per month returns are more the norm for less volatile stocks and during less market volatility.
This dual passive income and risk management strategy can be a game changer, however, especially for retirees, when dividends and bond yields are so low. Since the same capital is used to earn both dividends and call option income, overall stock risk is lowered.
One problem is that covered calls are a bull market strategy. While they are an easy income strategy for stock investors, they rarely completely protect the capital an investor has in stocks or stock ETFs.
Covered Calls to Protect Large Stock Positions
Covered calls be be an excellent strategy for an investor that has thousands of shares of company stock bought at a low cost over the years. The investor needs to be aware, however, that if the call option is exercised, the stocks must be sold.
When using this straetgy, out of the money call options can be sold to lessen the liklihood of the options being exercised. While selling out of the money calls brings in less option premium income than near the money call options, the income can easily equal, if not exceed, dividend income.
For covered call writers that sell call options inside IRA’s, the investor may not mind if the option gets exercised since he can simply buy the position again without tax consequences. (Check with your CPA since we do not give tax advice.)
Collars
A collar is a combination of a covered call and buying a put option. In other words, you’ve got a collar (limit) on both your loss and your gain.
With a collar, you get the income from selling the call option. Plus, your loss from owning the underlying stock is limited since you own a put option.
At Power Cycle Trading, collars and other more advanced strategies are typically taught and used by our members because of the advantages they provide to both generate income and lower risk.
How to Protect Stock Gains
You’ve seen four ways to protect stock gains with options.
While options can be a valuable risk management tool, it’s important to understand that there are a few simple basics that everyone should know before trading options.
Understanding option pricing, potential risk, volatility and time decay, in particular, are all important concepts to grasp using options to protect stock gains.