Investing in the stock market is inherently risky. Your fortunes can go up or down on events that may not have anything to do directly with the securities you own which can be extremely frustrating. Well fear not there are several ways to protect your stock positions from dramatic declines. One option is buying puts on the stock; another is through the use of a collar option.

Buying Puts on Long Stock Positions

Investors who own shares of stock are naturally exposed to downside moves in the stock. This is the risk investors bear for the possibility of unlimited profit should said shares rise to the moon. However there are times when investors become wary of an upcoming time frame, whether it is ahead of an event, general macro trends, or even a product announcement that could alter the face of the company. These investors should consider buying puts to protect themselves from sharp stock declines.

The advantage of buying puts for protection is the downside of that position becomes fixed for the duration of the option’s life. An illustration of long stock + long puts (synthetically equivalent to long calls) is included below. One disadvantage to the long put is cost. Investors have to pay up for that protection and if the put is purchased ahead of a known company event that the market perceives will push the stock significantly one way or another, the cost of the put will likely be higher (due to increased implied volatility) than the cost under normal conditions.

The Collar Option as an Alternative

Investors looking for a cheaper way to hedge their stock position and lessen some of the implied volatility concerns should consider the collar option. The collar option combines the purchase of a downside put with the sale of an upside call option. In this scenario the investor would pay less for the hedge (fixed floor) due to call sale proceeds that end up paying for some portion of the collar option cost. The collar option trade can be structured to where the cost of the put is paid entirely through the sale of the call option and the investor pays nothing out of pocket, this is referred to as a zero cost collar. But like we said before, nothing in life is free. The lower price of the collar option comes at a cost, primarily giving up some of the upside in shares. Under the collar option strategy, the investor ultimately locks in a trading range for shares, an effective risk management technique in volatile markets. A payoff diagram of a long stock + collar option is highlighted below:

Effective Use of the Collar Option

The collar option is an effective hedging tool. Officers of corporations sometimes have a sizeable portion of their compensation packages tied up in restricted stock that they are unable to sell for a given length of time. Instead of just sitting on gains in the stock and hoping shares don’t fall by the time the restricted period ends, some officers decide to structure a collar option which would lock in gains (at the expense of further upside). I’m sure a lot of the internet entrepreneurs pre-bubble wish they would have utilized these collar option strategies when their cash bleeding companies where trading at ridiculous 200x+ multiples during the boom.

For further information on the Collar Option and other Options Trading Strategies visit OptionsUniversity.com.