When the markets start to swing, holding a big parcel of shares can be a bit nerve-racking. The paper value of your shares can vary greatly from one day to the next.
It is something we have seen frequently over the last six months. The Dow Jones Index peaked just below 27,000 in October last year. However, by Christmas, the markets were almost in a free fall.
When the Dow smashed down through 22,000 on Christmas Eve, it marked a 20%-plus fall in less than three months.
Yet on Boxing Day, the market strongly reversed. Forming an almost perfect V-shape, the Dow was back trading above 26,000 points within eight weeks.
Sometimes it seems if you just switched off your computer, you would save yourself a lot of unnecessary heartache.
After a sustained and substantial fall like that into Christmas, it doesn’t take long to start kicking yourself for not getting out sooner.
But extricating yourself from the market can be an emotional roller-coaster. There might be shares you have owned for a long time. Plus, you rely on their dividends to supplement your income.
The other thing is the mind game. What happens if you sell out, only for the market to bounce…as it did at the start of this year? Now that is when you really start kicking yourself.
The cost of insurance
If you decide to ride out a volatile market, there are a number of ways to protect your positions. If available, you can buy put options over the shares that you own. A put option gives you the right to sell your shares to the option writer (seller), at the option’s strike price.
For taking on this obligation (to take your shares), you pay a premium to the option writer.
Buying put options can be a handy way to lock in protection. It can, however, become expensive — especially if you own a lot of different shares.
Because of that, some investors might buy a put option on the index itself. On the ASX, you can trade index options (XJO), which cover the S&P/ASX200. Because the index covers the top 200 stocks, it represents around 80% of the entire market.
If most of your shareholdings are from within the ASX200, an index option can be a useful (though, not perfect) way to protect your shares.
Again, though, buying index put options can really start to add up. Especially if you buy them regularly throughout the year.
There is, however, another way to protect yourself using put options. But instead of just buying the put options by themselves, you can add another leg to help finance the trade.
The trade is a collar, or ‘protective’ collar, and it uses both a put and call option.
Two legs, lower (or no) premium
Let’s say that BHP Group Ltd [ASX:BHP] is trading at $37. And please note this is not a recommendation — it is for illustrative purposes only.
You own BHP shares and decide you want to buy a put option at $35 to protect you from a fall. Meaning, you can offload your BHP shares to the put option writer at $35, if you decide to exercise your option.
To buy a $35 put option with around two months until expiry, costs around 45 cents per share. By paying that 45 cents, you have bought yourself insurance for the next two months.
You can exercise your option at any time up until it expires. If you exercise it, the put option writer must take delivery of the shares.
However, the share price has to fall below $34.55 before the trade is worthwhile. That is, the strike price of the option ($35), less the premium you paid (45 cents).
This is where the next part of the trade kicks in. To help finance this put trade, you can write an option yourself — this time, a call option.
By writing a call option, you receive a premium for the obligation you are taking on. That obligation is that you will hand over your share at the option’s strike price, if the call option buyer exercises their option.
In this example, let’s say we write a call option on BHP at around $39. By writing that call option, we must hand over our BHP shares at $39, if the call option buyer exercises their option.
With BHP trading around $37, a $39 call option with around two months until expiry will generate around 50 cents in premium per share. In other words, by writing the $39 call option, the premium you receive exceeds the cost of your insurance — the put option.
So what does this collar trade mean?
You must hand over your BHP shares if the call option buyer exercises their option. Meaning that you could be giving up some profits if the share price rallies above that strike price. Though, you get to keep the premium you received.
However, if you are comfortable potentially giving up some profits on the share price, the premium from the call option finances the cost of the put option. Meaning a collar trade can protect you if the share price really tanks, without outlaying any funds of your own.
All the best,
Editor, Options Trader
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