How would you like to have a stock position where you can’t lose? If the stock goes down, you are guaranteed to sell your stock higher and still make a profit. If the stock continues to move up slowly or sideways you continue to make money. The only downside is you are capping your profits. Hedging with options doesn’t have to be complicated. If this sounds good to you, keep reading! Let's talk about collaring your shares to lock in profits.
A collar is two separate options. You must have 100 shares to collar your position! You sell a call (AKA a covered call) and you buy a protective put (AKA a long put). I often add both trades at the same time, but of course you can “leg” into each part separately. I'm a visual person, so lets look at an example. On the chart below look at the two red lines I drew. You would sell the 200 call, and buy the 195 long put.
This is what it looks like on the options chain: the red box on the left is the covered call, the red box on the right is the long put.
I will break this down more below.
The covered call pays you a credit. This is the red box on the right. We’ve talked about covered calls previously. As you recall this is an agreement to sell your shares at 200 before Jan 19th. Keep in mind you are still capping your upside if the stock goes above the strike of your call (a collar doesn't change that). Many times you can roll this call out in time and keep reselling them for higher strikes as long as the stock doesn’t move up to quickly (same as with a covered call).
In the example above we could collect $3.52 to sell the Jan 200 Covered call. So if the stock goes over 200, we're agreeing to sell our shares.
The long put costs you money the red box on the right in the graphic above. You will have to pay for the insurance, but this put gives you the right to sell your shares at 195 before Jan 19th. As the stock drops you have the right to sell your shares. For my more advanced traders you can also sell this put for a credit if you want to keep your shares. This reduces your cost basis!
In the example above we are buying a Jan 195 put for 2.30. If the stock goes below 195 we have the right to sell our shares of Apple at 195 if it drops.
The power of the collar is the covered call is paying for the cost of the long put. At the bottom of the graphic above you can see we collected $1.22 to collar Apple. We collected $3.52 on the covered call, we had to pay $2.30 for the put. A covered call will always pay us more, but we have no protection to the downside with a covered call other than the premium we receiged! So yes, we collect less premium, but we have insurance!
This example above shows putting on a collar for a credit.This is referred to as selling a collar because I am getting paid for the collar. Receiving a credit is my favorite method for collaring a position. If the stock stays between the covered call and protective put I will collect the credit which continues to reduce my cost basis and I can put another collar on, hopefully getting another credit.
Sometimes I will put on a collar and pay a debit which is referred to as buying a collar. I pay a debit to collar a position if it’s a small percentage of my win. If I’m up 5.00 a share, I don’t mind paying a debit of .25. Would you pay $25 to lock in a win of $475?
I only put on collars when I’m profitable. If you are not profitable you risk getting called away on your shares for below your cost basis. I would rather hedge my position with long puts, put spreads, or just sell the position instead of adding a collar.
I collar my stock when it’s reaching resistance or a moving average and I have a sizable profit on my position. I loe to sell collars after several up days and when the stock is reaching resistance, or right before earnings. Remember we are insuring our position from the downside with the long put and just like insurance on your car or home you have to pay for it.
I use collars instead of just covered calls in several situations, I will give you some examples below.
Collaring a winner before earnings is a great strategy! As you know earnings can be volatile. Lets look at this example with Google. As you see on the chart Google has earnings after a pretty nice run since last earnings.
As you can see below, my stock is up $4,711 so I'm going to sell the 143 Covered call, and I'm going to buy the 135 long put for a credit of .30. Again I know this is a recap, but I'm agreeing to sell my shares at 143 with the short call and I'm locking in my profits by having insurance to sell my shares at 135 with the long put
This is what Google did on earnings. It gapped down!
If I only had a covered call I would have collected $330, but I would not have any down side protection. Look at my collar's profit and loss below!
The long put is up $1,017 and the covered call is up 330. So now I can close both of these options and lock in the cost basis reduction. Or I can hold on to the long put and agree to sell your google shares if it stays below 135 at expiration. There are some other options I have, but you'll need to join GKT's discord to discuss those. Did I mention the discord is free?
So as you can see collars a great over earnings, the biggest 'risk' you have is capping your upside. If google gapped up to $150 a share I agreed to sell my shares at $143.30. Also as I've preciously stated we don't collect as much premium as we do when we only sell the covered call. If the stock I have collared continues to trade sideways and I can sell collars repeatedly, meaning I get a credit, I continue to reduce my cost basis.
Collars also help me avoid paying taxes on some of my shorter term winning positions. I generally like to try to hold a position more than a year for tax advantages. So, if the stock drops like the example above with Google I will often sell the put I bought when the stock hits support. The covered call would expire worthless which also reduces the cost basis. So I made some money without realizing the entire $4,000 short term capital gain. Yes I pay short term taxes on the options, but I can retain my shares.
Using collars is a very effective strategy to not only hedge your stock, but also reduce your cost basis. It's important to know the difference between a collar and a covered call. There are some variations to collars that we can discuss in a later article as they are a little more advanced.
If you want more information you should join the GKT discord to discuss these tips in more detail and connect with like minded people who trade the stock market! I hope this article was valuable to you. We want to help educate and show you trading doesn't have to be complicated, and you can do this. Happy Trading Good Kids!
Disclaimer: this is NOT financial advice. I’m basically just some dude on the internet who’s been trading a while, and I use the stock market as my primary source of income. None of this is financial advice it’s purely educational!