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After the huge surge in stocks, plenty of investors are sitting on outsized gains. Many may be starting to worry about a pullback.

One way you can protect yourself is by buying a put option. That gives you the right to offload your shares at the option’s strike price at any time until the option’s expiration.

But while a put option protects you, it can be expensive – especially if you have a large number of stock holdings you want to protect.

So today, I want to run through a strategy that can offset that cost…

A “Collar” Options Strategy in Action

Let’s look at a “collar” (or “protective collar”) strategy. A collar is a two-pronged option trade:

1. You buy a put option to protect yourself against a stock falling. Buying a put option gives you the right to sell your shares at the put option’s strike price.

2. To fund the purchase of those puts, you also sell a call option.

To see how the strategy works, let’s use Meta Platforms (META) as an example. (This is just an example, not a trade recommendation.)

Say you own 100 META shares. META is trading around $785. It’s up around 65% in just four months. So you’re worried that it could get caught up in a sell-off. You want to protect yourself from a fall.

First, you decide to buy a put option. A put option with a $760 strike price costs you $15. (That’s $1,500 out of pocket per option contract – each contract covers 100 shares.)

As you can see, it’s expensive insurance given META’s high stock price. (Note that the closer the option strike price is to the current share price and the more time you have until its expiration date, the higher that premium will be.)

By buying that $760 put option, you’ve gained the right to sell your META shares at $760 (lower orange line on the chart below) until the put option expires.

Meta Platforms (META)

Source: e-Signal

This is where the second leg of the strategy comes into play.

To help offset the cost of buying the put option, you sell a call option at a strike of $810. That’s the upper orange line on the chart.

You need to use the same expiration dates for both your put and call options… and place both trades simultaneously.

For selling that $810 call option, you receive $15 (or $1,500 per contract). So the cost of buying the put option is offset by the premium received from selling the call option. In this example, there’s no overall cash outlay.

The important thing to understand is that selling the call option comes with obligations. You must hand over your META shares at $810 if the call option is exercised – even if the stock price is trading much higher.

Understand Your Option Trade’s Obligations

If META keeps rallying, you’re locked into selling your META shares at $810 until the option expires.

So before placing the collar trade, you need to be satisfied if you have to hand over your shares at the call option’s strike price.

But if META falls, you can sell your shares at the put option’s $760 strike price anytime until the option’s expiration – even if META drops to zero.

As you can see, a collar is a worthwhile strategy to have in your toolbox – especially if you’re sitting on profits and are worried about a fall.

While it caps potential profits, the sold call subsidizes the cost of buying the protective put. That can be a big benefit when you’re worried about a fall.

Happy Trading,

Larry Benedict
Editor, Trading With Larry Benedict