The world of investing is more complicated than buying and selling stocks with the occasional side of index funds. Options are a powerful tool to add your investing portfolio, but what’s the best strategy for options trading?
If you are new to the world of options trading, let’s get you up to speed first!
What are Options?
Options give you the right or impose an obligation on you to buy or sell a stock at a set price (called “strike price”) until a specific date (also known as expiration) regardless of the actual share price.
There are two main types:
When you buy “call options” you are taking a bet that the stock’s price will rise. But when you begin a trade by selling call options, you are betting that a share price will be capped at a certain threshold level.
Buying call options gives you the ability to purchase shares at a specific strike price, so if the actual share price is higher than the strike price, you basically get an immediate return on your investment (as long as the difference is more than the premium you paid for the call.)
You can also buy and sell “put options.” When you start a trade by buying puts, you are betting that the price of the stock will fall. Of course you could start a trade by selling a put option in order to create a trade that wins when the share price rises, or even stays flat for a period of time.
Buying calls and puts creates high potential for profits. But the risk for losses is just as significant.
To limit your possible losses, many options investors employ protection strategies. While there are many ways to do this, the collar trade is one of the most popular.
What is the Collar Trade Options Strategy?
A collar trade involves limiting your downside potential at the cost of limiting your upside return.
You can create a collar position when you buy a stock while simultaneously purchasing puts and calls to protect your position on a share-per-share basis.
For instance, if you own shares of Sirius XM [NASDAQ: SIRI] stock and it is valued near $5 per share for the purposes of this example, sell calls a little above where the stock is priced and buy puts close to the share price.
The rule of thumb is for every 100 shares of stock you own, you would sell 1 call contract and buy 1 put contract.
You can reach max profit if Sirius stock reaches or exceeds the strike price of your call.
Your biggest potential loss would come from the ABC stock reaching the strike price of your put or falling below that measure.
How the Collar Trade Limits Risk
Normally, options investors choose this strategy to limit their risks or to protect a stock that they already own when the short-term outlook is bearish, but the forecast is bullish over the long-term.
Collar trades also work well if you are close to the target selling price. This way you can limit how much you could potentially lose if the share price took a sudden hit.
What are the Drawbacks of a Collar Trade Strategy?
The biggest drawback of the collar options trading strategy is that, no matter how high the share price of your collared investment goes, your potential upside is going to be limited by the obligation of your call option.
In addition, your upside is going to be eroded by the cost of purchasing the put options you are using to collar your investment.
There is also the risk of “early assignment.”
In the United States, stock options can be exercised on any trading day. The person who owns the call option you sold decides when he or she will exercise it.
Note that because you own the long put position, early assignment does not apply, but it is definitely a concern anytime you have a short call position.
Post Expiration Stock Selloff
You need to consider what you want to happen with your stock after the expiration of your options as well.
Normally, options are exercised automatically on the expiration date. When you have a collar position, exercising your options will mean that the stock you collared will be sold if the share price is above the call price.
If you do not want to sell the stock, you will need to close your options before they expire.
Finally, there are tax considerations.
The timing of the put option in your collar, the strike price of your call position, and the time from the purchase of your call until its expiration each influences how long you hold the stock and that may impact the tax rate you pay.
If you buy a put option to protect your stock at the same time that you buy the stock, this is a “married put” and it won’t affect the holding period of the stock as it matters for taxes.
Likewise, if you hold the stock for a year before you sell, then you are going to be able to use long-term tax rates.
However, if you have owned the stock for less than a year before you buy your protective put, the holding period of your investment will reset for tax purposes.
Is the Collar Trade Right for You?
Options trading can help you take your investing game to a whole new level, but it comes with some important risks.
Collar trades help to limit that risk while potentially earning a reasonable return. Pay special attention to your market forecast and how easily you can make a trade if the share price starts to trend up or down.
While the collar trading strategy limits your potential upside, the trade-off may be worth it, particularly for more conservative investors. Remember, the collar trade doesn’t help you make more money. It prevents you from losing too much.
To get started trading options, visit top options trading broker tastyworks.
The author has no position in any of the stocks mentioned. Financhill has a disclosure policy. This post may contain affiliate links or links from our sponsors.