Traders have a love/hate relationship with volatile markets. We love them because trends can be very fast and extended and we hate them because the market can move very quickly against us. Aggressive traders seek ways to speculate and increase their market exposure during these periods and more conservative investors attempt to do the opposite.
If you fall into the second category then the options strategy we will discuss in this series is a tool you will want to add to your trading kit.
During volatile markets, traders seek to offset some risk through protective puts. These are a good idea because if the market drops down significantly the put will increase in value, which offsets potential losses on your long stock position. The real drawback of a protective put is that the option can be quite expensive to purchase in the first place. The premium you pay will offset many of the gains you could earn if the market breaks out to the upside.
One solution to this problem is a collar. The collar trade consists of a protective long put position that is as far out of the money as a short or “covered” call sold against the same stock with the same expiration date. The premium received from the call offsets all or most of the premium paid for the put making that protection much less expensive.
Usually you can anticipate paying a small net debit to enter this position. By entering a collar option position against a long stock position you have offset a lot of your downside risk but also limit your upside. Typically, traders will apply the strategy when they are long a stock and don’t want to sell at current prices but would find a small price improvement acceptable.
John Jagerson is the author of many investing books and is a co-founder of LearningMarkets.com and ProfitingWithForex.com. His articles are regularly featured on online investing publications across the web.