News Analysis date published New: 
Thursday, January 10, 2013 - 13:00
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Thursday, January 10, 2013 - 13:00
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Thursday, January 10, 2013 - 13:00

How To Protect Your Profits for Free

Thursday, January 10, 2013 1:00 PM

Here's a situation every investor faces sooner or later...

Imagine you are sitting on solid profits from a stock you foresee climbing higher. But then a little bad news hits the newswire, sending the stock lower.

The news becomes modestly worse and price dips again before stabilizing several points off the high. Investment message boards are on fire with pros and cons about the company. It becomes difficult to find an overall consensus on the stock that has been so good to your portfolio. Even analysts are presenting conflicting data about the company's future.

Should you sell now to lock in your profits, or keep waiting for the upside to continue?

Making this decision is particularly difficult when the stock that pays substantial dividends.

If you hold on to the stock, then you could keep collecting the quarterly dividends, but your capital gains could quickly diminish if the stock price keeps falling. If you dump the shares to lock in the profits, then you are giving up on all potential additional upside and the steady flow of dividends.

Fortunately, there is an easy way to hold on to your winning, dividend-paying stock while protecting your investment from any downside.

Investors who want to limit the downside risk of a stock position at little or no cost should use an easy-to-use option strategy known as a collar.

What is a collar?
A collar is the simultaneous purchase of a put option and the selling of a call option. For those of you new to options, a call option gives you the right to buy a stock at a particular price. It can also be thought of as a bullish bet on a stock. A put option, on the other hand, gives you the right to sell a stock at a certain price (strike). It can be thought of as a bearish bet on a stock. In a collar strategy, both options are out of the money and generally have the same expiration date. An out-of-the-money call option means the strike price is higher than the asking price for the underlying stock. An out-of-the-money put option means the strike price is lower than the asking price for the stock.

The option expiration date is usually the third Friday of every month. On this date, all options that are out of the money expire worthless. The mechanics of a collar are for every 100 shares of stocks you want to protect from downside, one put is purchased and one call is sold at the same time.

For example, if you own 1,000 shares of XYZ, then a collar would consist of buying 10 put options and selling 10 call options to protect all 1,000 shares. The options are dated for how long you are seeking downside protection. If you believe things will stabilize in five months, then the expiration date would be five or more months. Stated simply, the premium received for the call options is what is used to offset the purchase price of the protective put options.

If you are able to establish the collar at no cost due to the call premium received, then the trade is known as a zero-cost collar.

An example
You own 1,000 shares of XYZ stock that's trading at $35 a share. Some bad news has knocked the stock off its highs of $37 and you are afraid it could easily go lower in the next several months.

To keep your investment, you decide to use an option collar for downside protection. This means you'll be buying 10 put options five months from expiration at the $32 a share strike price for $2 per option ($2 x 100 shares = $200) or $2,000 for 10 options. Simultaneously, you sell 10 call options, five months from expiration with a $38 a share strike price at $2 per option ($2 x 100 shares = $200) or $2,000 total. This creates a five-month zero-cost collar to protect your stock investment from downside.

Risks to Consider: Although collars are considered relatively safe, there are inherent risks in every option transaction. It's also important to note that using a collar could cap the upside potential in a stock. Please read the Option Industry Website for details on option risks. In addition, taxation issues beyond the scope of this introductory article can also arise when using options. Be sure to consult a tax professional prior to entering any option position.

Action To Take --> Option collars are particularly valuable for investors whose net worth is comprised of any single stock position. While a zero-cost or positive-carry collar (when the cost of the puts is less than the premium obtained from the calls) is ideal, the most common scenario is offsetting the put cost, rather than completely eliminating it. Option collars can be powerful tools for investors when used prudently.

[Note: My colleague Amber Hestla of ProfitableTrading.com is putting the finishing touches on a report that answers 10 commonly-asked questions about boosting income with options. If you'd like learn more about generating income using options, simply click here and tell us where to send the report.]

David Goodboy does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.