The S&P 500
is within 3% of a record set in early September, and with the benchmark index doubling since its pandemic low in February 2020, the risk of a correction is growing.
Some investors are wondering what steps they can take to protect their positions and portfolios, without trying to time the market by selling before it drops and buying back in before a recovery is in full swing.
There are ways for investors to hedge their positions and protect their profits. The term “hedging” goes back to medieval times when property owners would plant hedges around their home like a fence for protection.
Most investors should stay invested for the long haul and ride out periods of inevitable market volatility. If they try to time the market, they tend to return to the market too late, and that erodes long-term returns.
At some point, we will experience another economic recession, which are usually accompanied by bear markets. The terms “bull” and “bear” markets go back to early California history when they would stage fights between the two beasts. The bulls would strike up with their horns while the grizzlies would stand up and strike down with their paws, so bull markets go up and bear markets go down.
One way of protecting positions is by using options. First, definitions:
An option is a derivative security that allows the buyer to buy or sell a security at a particular price within a set time frame. That price is known as the strike price.
A call option allows the purchaser to buy, while a put option allows the purchaser to sell.
A stock’s ex-dividend date is the date when it trades without the value of its next dividend included. All things being equal, a stock’s price will decline by the amount of the next dividend on the ex-dividend date. If you hold a stock before the ex-dividend date, you will receive the next dividend. If you buy it on the ex-dividend date, the seller will receive the next dividend.
Options are not suitable for all investors. A common options strategy is known as a collar. To put on a collar, you sell a call option and use the funds received from the sale of the call option to purchase a put option. It’s called a collar because you limit your upside potential by selling the call and your downside by purchasing the put.
When you sell a call, you are obligated to deliver your stock or shares of an exchange traded fund at the strike price by the expiration date if the underlying security is above that price. (In industry parlance, your position is “called” or “called away.”) If you purchase a put option, you have the right, but not the obligation, to sell your holding at the strike price by the expiration date.
Typically, collars are put on for a credit, meaning you receive cash for establishing the position and you keep that premium if the underlying stock stays in between the two strike prices. You can also put them on at neutral cost or for a debit — it all depends on the strike prices that you choose to limit the upside and the downside.
When you select the expiration date, you can determine how long the collar will stay in place. Some investors like to collar holdings around earnings reports or other news or economic events that can drive share prices up or down. Options can be useful tools, but they also require sophistication, and the risks and rewards need to be fully understood.
Example of a collar
Let’s say you purchased 100 shares of AbbVie Inc.
on Sept. 17 for $107.40.
You could have sold one call option expiring Nov. 19 with a strike price of $115 for $1.12 per contract. This is known as a covered call option because you already own the stock. If the share price rises above $115 by Nov. 19, you will most likely be forced to sell at $115. Your profit will be $7.60 a share, plus you keep the $1.12 a share premium you earned when selling the option. If the share price hasn’t risen high enough for the option to be exercised (for your stock to be called) by Nov. 19, you keep your $1.12 premium and are free to write another option.
For a collar, you would have purchased one put option expiring the same day, for 80 cents a share.
AbbVie’s quarterly dividend is $1.30 a share. The ex-dividend date is Oct. 14, the pay date is Nov. 15, and the stock’s annual dividend yield, based on the price of $107.40 you paid on Sept. 17, is 4.84%.
To establish this collar — which in the industry would referred to as a November 115 X 90 collar — you get a credit of $0.32, or $32 (one hundred times 32 cents). So you have sold one November $115 call option for $112 and purchased one November $90 put option for $80. The difference between the $112 credit and the $80 debit is a $32 credit, which you keep. (For this example, commissions haven’t been factored in.)
If your stock is called, your maximum gain is $9.22, or $922 in 63 days, an 8.5% return in that time.
Your maximum loss with the 90 puts would be $15.78, or $1,578, which is 14.7% in 63 days.
Kenneth Roberts is a registered investment adviser based in Truckee, Calif.