Strategy: 2 Ways To Manage Portfolio Risks With Options

In uncertain markets, every investor is fearful about possible losses in a stock portfolio. But other than getting out altogether, what can you do to eliminate that ever-present risk?

Here are two options strategies worth considering for portfolio management:

  1. Collar for loss prevention. The collar is a smart move when you are holding appreciated stock. Rather than risking a loss due to decline in market value, open a collar. This consists of a long out of the money put and a short out of the money call. Because both are out of the money, the options will be fairly cheap and you might even be able to create a net credit, meaning you get market risk protection without having to pay for it. For example, you bought 100 shares of stock @ $32 per share. The stock is currently price at $37. A collar could consist of a long 35 put and a short 37.50 call. This can be varied, of course, to get the desired net debit or credit. If the call is exercised, it creates a capital gain of $500 before trading costs; and by the way, if the call does go in the money, you can roll it forward to avoid exercise and to set up a higher strike. If the price drops below the put’s 35 strike, you can exercise the put before expiration and sell shares @ $35 per share, a profit of $300 before trading costs. If you think of the option trades as a single transaction, your net cost should be at zero or even a small profit. So exercising the put does not create a net loss in the option. The collar freezes your market risk and programs in profits with exercise of either option. However, it also places a ceiling on maximum stock profits if the stock price moves above the call’s strike and it is not closed or rolled.
  2. Protective put. The easiest of all is the purchase of one put for 100 shares. This can be a very affordable type of insurance, and it eliminates market risk below the net cost. For example, if you bought shares @ $32 and the put costs you a net of 0.70, your breakeven point is $31.30 per share. If the stock falls below that level, the risk has been eliminated. You can exercise the put and sell shares at $32, or close and take profits on the put.