The Collar Strategy Can Protect Your Stocks Using Put Options

Hoping and praying that the stocks that you just bought will go up is not the best strategy to use, however it is the one very often used by the average Joe stock trader. The only salvation they have is that in bull markets most stocks will go up.

Statistically speaking the best way to make money is by trading with the trend. This is because in a bull market 15 out of 20 stocks will follow the trend and this will give you the best odds of making money. In the same way in a bear market it is also best not to try and fight the trend but to go with the flow and either sell all your stocks and go to cash, or short the market.

Even in a clear bear market there are reasons why some investors would not want to sell their stocks, this could be for tax problems or because they inherited the stock from a relative. Without taking some action they could suffer a large loss, but fortunatley by using options some downside protection can be obtained. Using Call and Put options in two strategies called Covered Call and the Married Put the losses can be limited.

Option trading can be very confusing and difficult at 1st, actually it's not that complicated once you have had a good education in the subject. However if terms like Put and Call Option, Married Put and Covered Call don't mean anything to you, don't attempt to trade options until you get that essential education in the theory.

The Covered Call strategy involves selling call options against the stock the you already own, in 100 share blocks. If the stock goes down the call options lose their value and compensate you in part for the loss in the stock price. However if the stock goes down by more than about 3-5% then you will lose more money in the stock than gained using the call option.

The big problem with the covered call strategy is that it only provides very limited downside protection and if the stock takes a big cut like 25%, which can happen, you lose big time and only recover about 3-5% of the loss.

The better solution to providing downside stock protection is the option strategy called the Married Put. As the name suggests the PUT that you buy is used to provide protection when the stock goes down because Put options increase in value when the stock decreases in value. The term married is used because the option that is selected has to be very compatible with the stock, in other words a good match, if the strategy is to work.

The selection of the best Put option is not straight forward and involves several criteria which are listed below:

1. What strike price is selected for the Put option

2. The current stock price

3. Either in or out of the money Put options

4. Put expiration time

Even though the married Put protection only has a limited life span if offers much more protection than the covered call. It can provide as much as 95% loss recovery in the event of a significant drop in the stock price.

The disadvantage of the Married Put strategy is that you have to buy the Put option, i.e. it costs you money, whereas the covered call is a net credit, whoever said option trading was easy?. Having said that I have not yet told you the full story of the Married Put, there's much more. There are ways of off setting the cost of the Put so that this strategy becomes self financing and can make heaps of money when the market is very volatile.

The general idea of the Collar Trade is to combine the covered call and married Put strategy into one, this is what is called the Collar Trade. In effect you put a collar around the stock, sell a call and buy a PUT. If you do this correctly most of the cost of the Put can be offset by the credit from the covered call so you can protect your valuable stock at almost no cost. Yes this is a great strategy which the general public is unfortunately very ignorant of, and most brokers don't understand.