Let's face it: there are a lot of ways to make money in the financial markets. That's the good news. The bad news is that there are a whole lot more ways to lose money. In essence, most of investing comes down to timing of one form or another. I'm not even necessarily talking about any kind of magical "precision market timing" method. All I am saying is that "the sum of all investment knowledge" basically comes down to this:

a) Does it go up far enough before,
b) going down too much in the meantime and,
c) do you get out soon enough but,
d) not too soon?

Put it all together and it comes out like this: "Does it go up far enough before going down too much in the meantime and do you get out soon enough but not too soon?"

Okay, got that? Just kind of rolls right off the tongue, doesn't it?

In any event, whether you are buying stocks, mutual funds, futures, individual call or put options, FOREX markets, etc., every plan that you make and every action that you take affects one or more of these steps. In essence, how you work this "formula" determines your success or failure. However, the point of this week's piece is that there is a way to alter this formula and skew things more in your favor. And that is via the use of options. For once an individual gets past the idea that the key to riches in option trading is to buy cheap out-of-the-money calls and puts (which invariably end up expiring worthless more often than not) and/or to write covered calls (which essentially caps one's upside potential, as we will see in a bit), if they persevere and gain knowledge they soon learn the variety of option trading strategies that can help them to take advantage of opportunities that they previously could not.

One option trading strategy that gets a lot of coverage from Optionetics instructors, and rightfully so, is known as the "collar." In a nutshell a collar involves selling a call and buying a put on a stock you hold in order to lock in a particular reward-to-risk scenario for a period of time (specifically, up until the time the options expire). There are many ways to select when to put on a collar and which options to use. Much of the more advanced analysis is covered in more advanced Optionetics courses and seminars. Still, it is fairly simple to learn and appreciate the value of a good tight collar via a couple of examples.

Hedging a Stock that has had a "Run"

Right now may be a good time to consider collaring certain stocks that you may hold in your portfolio. That is because many stocks have enjoyed big moves since the first part of March as the stock market rebounded sharply following the "mortgage crisis/financial mess/etc." Collaring a stock allows you to:
• Minimize your downside risk to a small dollar amount.
• Enjoy a favorable reward-to-risk ratio.
• Continue to hold the underlying security (rather than selling it now and having to decide if and when to buy it back later).
To appreciate the value of a good collar let's look at one example and compare it to a covered call on the same stock.

GT Collar

As you can see in Figure 1, Goodyear Tire (GT) has run from under $4 a share to above $13 a share in about two months' time. In addition, the latest Elliot Wave count is suggesting a pullback may be in the offing. A person holding shares of GT may now be wondering if it is time to sell or if he or she should be holding on in hopes of further gains.

Figure 1 - GT Stock - Pullback, run to higher ground or both?

In essence we are at the "do you get out soon enough but not too soon" stage. By "collaring" this stock an individual can essentially avoid making this decision. The collar that appears in Figures 2 and 3 involves:

Holding 100 shares of GT
Selling 1 June 17.5 call
Buying 1 June 15 put

Figure 2 - Collaring GT

Figure 3 - GT collar limits risk, affords favorable reward-to-risk ratio

As you can see in Figures 2 and 3, entering this position will limit the maximum downside risk between now and June option expiration to just $50 and change (plus any commissions). Granted the upside is limited to $200 while the collar is in place. Still that represents another 13% gain from current levels and if the stock continues to advance sharply, a well educated trader might consider "rolling up," i.e., exiting this collar and moving to higher strike prices in order to maintain a favorable reward-to-risk ratio. Likewise, if GT were to fall apart a trader could either "roll down" to lower strike price or simply wait for June expiration and reassess the situation then.

GT Covered Call

To fully appreciate the collar displayed in Figures 2 and 3, let's compare it to the strategy that the vast majority of investors use as a "hedge," the covered call. A covered call position simply involves selling a call option against a stock that you hold. Figure 4 and 5 display a covered call position that could have been entered at the same time as the collar displayed in Figures 2 and 3.

Figure 4 - GT covered call

Figure 5 - GT covered call: limited upside potential and an unfavorable reward-to-risk ratio

There are several key comparative items of note:
• Unlike the collar, the covered call trade does not offer limited downside risk. If the price of the stock starts to decline the trader must still decide what type of stop-loss action to take.
• Like the collar, the covered call has limited upside potential; however, unlike to collar position shown above, the covered call position has a very unfavorable reward-to-risk ratio. The maximum profit potential on the covered call position is just $100 with a downside risk of $1,150.

Harnessing the power to alter "the sum of all investment knowledge." Now there's something to think about.

Summary

It is incumbent upon traders to take whatever actions they can in order maximize their own profitability while minimizing the risk they are exposed to. Option trading offers traders many opportunities that are simply not available to individuals who only trade the underlying securities. The collar strategy as detailed in a simple example in this article is one of the strategies that fits this description. With a single transaction a trader can lock in a fixed – and highly favorable – reward-to-risk ratio, and simultaneously limit downside risk to a minimal dollar amount.

NOTES: 

I will be teaching a session on Seasonal-based trading at this year's Optionetics OASIS, June 18-21. I look forward to seeing many of you there. For more information about this incredible event, please click here.

To learn more about Seasonal Stock Market Trend: The Definitive Guide to Calendar-Based Stock Market Investing, please click here.

To sign up for a free 1-month trial of Optionetics ETF Investor newsletter, edited by Jay Kaeppel and Clare White, you can do so by clicking here. 


Jay Kaeppel
Staff Writer and Trading Strategist
Optionetics.com ~ Your Options Education Site
Questions for Jay? Please visit "Ask the Traders" through the discussion board on the Optionetics.com home page.