Times change, and investors must change with the times.
Since World War II, investing in the stock market has been necessary to keep up with inflation. But it was only 100 years ago that the idea of individuals investing in stocks would have been ridiculed.
The consensus for how a prudent investor should act has changed over the years. One part of prudent investing is diversification of holdings. Proper diversification requires more than simply owning stocks in different sectors of the market. It also involves owning different asset classes – a method known as asset allocation. It's common practice for fiduciaries to invest an individual's money in a variety of asset classes.
The rationale behind asset allocation is that all asset classes do not move in tandem. While one class may be undergoing a downturn, another asset class will be holding steady, or increasing in value, to offset losses. Obviously this minimizes profits during a major stock market rally, but that possibility does not dissuade adherents who believe asset allocation should be part of every prudent investor's methodology. Asset allocation is accepted at a risk-reducing investment idea. (See Asset Allocation: One Decision To Rule Them All to learn more about asset allocation.)
Follow the Herd or Think for Yourself?
We all want to accept the advice of professional advisers. After all, isn't that why we pay their fees? The problem is that these professionals place individual investors at a disadvantage by not using the best risk-reducing tool available: the stock option.
Efficient asset allocation reduces wild swings in the value of an investor's portfolio, but that's not good enough. As asset allocation gains adherents, danger looms: when too many inexperienced investors see a stock market decline, rather than depend on their chosen strategy – asset allocation – to prevent major losses, they panic and sell everything. That destroys the concept that when stocks are plunging, other assets can rally. Panic hastens the decline of other assets. Rather than depending on investors to act rationally, it makes sense to consider alternatives for protecting the value of your investments.
Fortunately, investors can ensure that their stocks hold almost all of their value, regardless of how severely the stock market declines. A simple option strategy, the collar, provides that protection.
As with other insurance, this guarantee does not come free. It's a trade-off. If you are willing to accept limits on profits, you can guarantee that your assets do not fall below a chosen level. This plan is not for the wide-eyed optimist who believes that stocks will rise forever. It's a conservative idea for anyone who wants to protect what has already been saved, and is willing to accept limited profits going forward. And one of the ideal characteristics of this plan is that assets can be divided, allowing an investor to insure any portion of a portfolio, with the remainder free to fluctuate as usual.
When others are gloating over huge profits during raging bull markets, you will be forced to settle for smaller profits. But, when everyone around you is getting clobbered by holding onto the dream (buy and hold), your losses will be very small.
Investors who adopt a collar strategy have all the protection they need. If the market rallies, the value of the portfolio increases. If the market tumbles, the investor is fully protected against significant loss.
Many investors like the idea of dollar-cost averaging, and add to their holdings when stock prices decline. As a collar owner, you can do the same. By not losing money on your holdings, it's comfortable to buy more shares at lower prices. (Want to learn more about dollar cost averaging? Read Fight The Good Dollar-Cost Averaging Fight to learn the pros and cons of this strategy.)
Let's see how a collar works, using a hypothetical example. This strategy is appropriate for each stock in your portfolio, if you own at least 100 shares. If you are a passive investor and own exchange-traded funds (ETFs) that mimic the performance of any of the major market averages, then you are in a good position to use collars. If you own more traditional mutual funds or index funds, you may like the idea of using collars so well that you decide to exit your current investments and instead, choose ETFs that have listed stock options.
Definition: A collar is an investment strategy used to establish a limit (or "collar") on both profits and losses. The collar is composed of three parts (legs): long 100 shares of stock, long one put option and short one call option.
Example: You own a portfolio that's invested in BBIF (broad-based index fund), currently priced at 51.23 per share, and your 1,000 shares are worth $51,230.
A. If you are willing to lose about 6% of your portfolio value:
Buy 10 BBIF Nov 48 puts
Sell 10 BBIF Nov 54 calls
November is a random selection. Choose an expiration that is appropriate, and that's usually one, three, or six months in the future.
The premium received from selling the calls can sometimes be enough to cover the cost of purchasing the put option. So this strategy allows you to get the downside protection you want at zero or low net cost, depending on the strike prices chosen.
Through options expiration, your shares can be sold at $48 per share, regardless of how low the price may decline. That means losses cannot exceed $3.23 (6.3%) per share (from today's prices), as long as the collar is in place.
Just as you chose the deductible on your collar (the amount you will lose in a worst case scenario), you choose the maximum profit. You do that by picking a strike price for the call option. When selling a call, you sell someone else the right to buy your shares, if BBIF is above the strike price when expiration arrives, the call owner will exercise the option and buy your shares by paying the call strike price per share. That limits your profits.
The higher the strike price, the more you can earn on a market rally. But, the premium received from the call option declines as the strike price increases, and that means you pay more for the collar. Most investors prefer to offset the entire cost of the put when selling the call. (For an in-depth overview of options, check out our Options Basics Tutorial.)
Collars are flexible. You choose the expiration month and strike prices. If you accept the premise that protecting the value of your holdings is your objective, then collars are far more dependable than asset allocation.
The problem with collars is that very few financial planners or advisors understand options, and many stockbrokers are not well enough educated to help you. For most investors, this is a do-it-yourself strategy.
In addition to using short-term options to design a collar, read Using LEAPS With Collars to learn about using longer term options to create collars. Also check out Putting Collars To Work to learn variations of the collar strategy.