The solution to this market... The "Equity Collar" Hedging Strategy
Thursday, June 15, 2006 | Chris RoweRating:
Hey You! Yeah, you at the computer! Don't look behind you, you know who I'm talking to, the Tycoon Report Reader with the funny haircut! Stop pulling your hair out of your head.
I won't try to predict the market, but I have some important thoughts to share with all of you. First, I want you to know that my short-term indicators are saying that while we are in oversold territory, the odds are that we still can come down a bit further.
I said to let go of your hair! Listen ...
What Has Happened, Where We Are, and What To Do ...
Just this past week:
- The New York Composite dropped 4.70%
- The S&P 500 was off over 40 points, down 3.18%
- The Dow Industrial Average traded down 296 points and 2.7%
- The Nasdaq Composite was down 4.18%.
We are now closer to what is considered to be the low risk/oversold level than we have been in a few years (the recent bear market bottom to be exact).
The market is considered to be low risk when 70% or more of stocks are on sell signals (again currently, 55% are on sell signals). The idea is that when 70% or more stocks are on sell signals, almost everyone who wants to sell has already sold.
So while we are not in a bear market, we are trending lower, and have not yet reached a level which is considered a "safe" place to buy new positions for the long term (but many traders like to buy stocks for short-term bounces in which case they are catching "falling daggers").
According to The New York Times, there has been 2 trillion dollars lost this last month in the global markets.
I know what you're thinking: Why didn't I sell everything when I was up!?
Don't beat yourself up. What tends to happen here is that you get so mad at yourself that it actually messes your head up so much that you start to make lousy decisions in the future.
We have seen a quick "bounce" here, but this is where you have a chance to reduce your exposure to market risk. You don't want to drop everything and buy stocks just yet.
If you don't have any bearish positions (like short stocks, or put options) then this would be a good time to consider doing so. You will sleep better at night knowing that some positions are actually profiting form a down market.
I have to tell you that when the market bottoms out, you tend to see capitulation. You see high volume, massive panic selling, and we haven't seen that yet. We have seen average volume selling, sort of trickling lower and lower. That is not the way market bottoms look.
I wouldn't panic-sell here either just because the CPI numbers were higher than expected (indicating inflation, and therefore future rate increases).
Be cool here. I know it isn't easy. But be sure that you don't become "that guy/gal" who sells at the bottom. Of course the market is down.
There is negative news out. I don't want to be a bear at the bottom of a market, or a bull at the top.
You may think that holding your positions is risky, and some would argue that selling this low is also extremely risky.
If your broker is panicking, or if your "other" trading service or investment newsletters are panicking, then believe it or not, YOU have to be the stronger one. YOU might actually have to calm the "pro" down.
Reducing exposure here is fine. Taking some bearish positions is fine. I'm not saying you shouldn't be protective, but don't panic and sell YOURSELF short. You are going to kick yourself if you sell stock and watch the market turn around.
So what do you do? You HEDGE.
What if you own stocks that you suspect will trade lower, but you decide you’re not quite ready to sell? What if you don't want to take the risk of shorting a stock, and taking a huge loss if the stock trades higher?
Today I'll show you a SIMPLE option strategy called an "equity collar," which is a way that you can hedge your stock positions against further loss without selling them.
An equity collar is when you sell the call option and also buy the put option with the same expiration month. You would typically do both trades one series out of the money.
If you want to LIMIT your downside, with some extra upside potential if you are slightly bearish on the stock, the "Equity Collar" is the way to go.
I'll give you an example using Google.
This is what you would do if you own a stock that you think may trade lower, but you don't want to necessarily sell it for some reason such as (let's say) a tax liability.
Google (Symbol-GOOG) is at $388.00 right now.
If you own the stock, the way you would implement this strategy would be to decide on the month that you want to be protected until. Try not to go more than 3 months out for the best results.
Remember, you can always re-implement the strategy in 3 months.
Keep in mind that for the period that you are protected, you are also limiting your upside. If the stock rallies, you will have to sell it at the strike price of the call option that you sold.
Once you decide how long you want this protection, you should implement the equity collar with options that expire within 1-3 months.
I'll clarify: Let's say that you think that between now and September, Google may trade higher, but also it has a very good chance of taking a dive. You don't want to sell it today because (let's say) you bought it 11 months ago and you want the long term tax benefit, which would net you a significantly larger after-tax profit.
You would:
1) Sell the September $400 calls which are at $25.00 (notice that this $400 call has a strike price ($400) which is 12 points "out of the money").
This means that I am selling someone the right to buy my Google stock at $400.
When you do step one, you will RECEIVE $25.00 per call (remember: Options typically represent 100 shares of stock. If you own 1000 shares of Google, you would sell 10 calls, and buy 10 puts).
2) Use that money that you have received to buy the September $380 puts which are at $23.00.
You would then use the money that is deposited in your account for selling those calls ($25.00/share) to buy the puts, which are at $23.00 – which gives you a credit of $2.00.
The puts are essentially free, and you even have an extra $2.00/share deposited in your account.
What you have done here is limited your downside risk to 8 points on the stock by purchasing the put options, and you took in 2 extra points credit since you sold the September $400 call. If the stock trades lower, since you own the put option, you have the right to sell the stock at $380.
Your maximum loss is 8 points on the stock ($388 is today's price, and you own the puts which give you the right to sell stock at $380). Since you have a 2 point credit, your maximum loss is 6 points on the over-all position.
The reason that we use an "equity collar" that expires a few months further out is in case the stock trades much higher than $400, the chances of your being called away from your stock position before your tax consequence becomes long-term, is significantly reduced.
The three possibilities:
1) The stock trades over $400 – If the stock is at least 25 cents over $400 at the time of expiration, you will be "called away" (have to sell your Google at $400, 12 points higher than today's price). This is a positive, because it is better than selling the stock at today's price out of fear of the stock trading lower. Here you make an extra 14 points instead of just dumping the stock at this price for free ($12.00 $2.00 credit = $14.00).
Your Bonus: If the stock gets called away BEFORE options expiration, then you will still own the put options! You can now sell them for some extra money, or hold them for a larger gain if you think the stock trades lower!
2) The stock trades under $380 – If this happens, you own the puts, which should be worth one point for every point that the stock has traded under $380. So if the stock trades to $350, your puts will be worth at least $30.00.
At this point, you can either Close out both option positions (meaning FIRST buy back the call options at a lower price which is a profit, and THEN sell the put options at a higher price, which is also a profit), OR let both options expire, in which case you would use the put contract to sell your stock at $380 even though Google trades in the open market at $350).
(If your reasoning was to avoid the tax bite, then closing out both options and holding the stock would make more sense).
No matter what, I would personally recommend closing out both option contracts about 3 hours before the market closes on options expiration day (which is always on the third Friday of the month, unless that day is a major holiday, in which case expiration is Thursday).
IMPORTANT: Before selling your stock, be sure to BUY BACK the call option that you sold. This is critical. You do NOT want to be SHORT the calls without owning the stock. If you are short the calls without owning the stock, you could end up being short the stock. So just make sure that if you sell the stock for any reason, you have bought back the call option FIRST. If you are selling your stock because you are being called away at
$400, then you are automatically NO LONGER short that call option.
No matter how low Google trades, you are only exposed to a 6 point loss (which would happen if Google traded to $380, because your puts and calls would expire worthless, and you would have that 2 point credit, and an 8 point decrease in the stock (8 - 2 = 6).
3) The stock trades between $380 and $400 – If this happens, you have a couple of options.
You can let the options expire worthless. You would make a maximum of 14 points, or lose a maximum of 6 points. Again, my personal recommendation is to close out both options positions.
I explained above why your maximum loss is 6 points. The reason that the maximum gain is 14 points is because you made a 2 point credit already, and the stock could also trade up 12 points (to $400) without getting "called away" (12 2 = 14).
The other option: if you don't feel the need for the equity collar any longer – at any point – you buy back the call that you sold, you sell the puts that you own, and make a profit on the difference.
No matter where the options are, you can always undo your implemented equity collar by buying back the calls that you sold, and selling the puts that you bought. You are never locked in.
That is what you might consider doing if you want to hold a stock that you think will trade lower, or even if you are considering selling your stock here anyway. This way at least you have the chance to make money on the downside, make money if the stock trades flat, or you can feel comfortable holding the stock with the chance to make another 14 points or so.
Once you feel the coast is clear, and the market holds less risk, then you can just go back to the plain vanilla play of owning the stock and having zero option positions.
You should also consider getting in the habit of selling calls on all of your stock positions. Unless the market is similar to the markets of 1997-2000, selling calls is always a great idea.
Sometimes it will work better than others, but if you get in the habit of doing it constantly, your portfolio's over-all performance should definitely improve significantly.
Anyone who is not familiar with the strategy needs to become familiar with it immediately, because they are really missing out.
I Hope this helps.
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“Profit from the Trend”
Chris Rowe
Chief Investment Officer
The Trend Rider
