How to Protect Stock and Generate Income Using Collars
People who want to protect their stock positions in the event of a stock market crash or bankruptcy can buy insurance known as put options. Put options allow you to sell your stock at a certain price for a set amount of time until the contract expires. Once the put option you bought expires you will have to buy another put option. These put options cost money and it will keep costing money as long as your stock is protected with put options.
A “collar” is a strategy where you sell a covered call on your stock position and at the same time buy a put option to protect your stock. This strategy is called a collar because it limits the possible risk and return. The covered call could cause you to miss out on a large gain if the stock goes way above the strike price. The put option would limit your downside risk since you could sell your stock at the strike price of the put if the value of your stock drops below the strike price.
A collar will allow you to protect your stock position indefinitely as long as you are ok with selling your stock at the strike price of the covered call and you always establish this strategy for a credit. Since put options are generally more valuable than call options it may only be possible to establish this strategy for a credit if the covered call is close to the money and the put a larger distance from being in the money. If your stock is ever called away from you through the covered call, you could just sell a cash-secured put at the same strike price to get your stock back if you want to. Since the covered call would need to be closer to the money you will probably end up alternating between covered calls and cash-secured puts fairly often. You will make money every time you sell an option so this is a good strategy as long as you are not holding onto the stock for tax reasons.
Using the collar strategy can reduce risk over time since you will eventually get to the point that you can take your original money “off the table.” For example, if you bought 100 of stock worth $20 and you establish a collar positon for $10 every week on average, you would double your original $2,000 in 200 weeks. When you double your money the risk of that trade is, in a way, zero. This is because no matter what happens after that point within that trade, you cannot lose your original $2,000 since you have taken it off the table.
When I first started learning about trading options I had an account that I doubled the value of in a very short time. I put the original amount into my bank after doubling the amount and after a couple more weeks of trading using only the profits I had already made, the account was at zero. I felt terrible wiping out an account like that but I learned a lot and in the end I really did not lose anything since I still had the original amount that I started out with back in my bank. Use the collar strategy for a credit with the intention of eventually taking your original money off the table, at that point you will have an asset that will produce cash flow with limited risk or no risk depending on how you look at it.