Coffee With Cott

Option Strategies That Can Potentially Protect Capital Gains

Coffee With Cott is a blog from The Options Industry Council's Financial Advisor Division. Eric Cott, the author, is a former advisor who has been the Director of Financial Advisor Education at the OIC since he developed the organization's outreach program in 2009. Coffee With Cott offers percolating insight on options strategies, as well as practice management ideas.

When you've got a client who's sitting on gains in their portfolio, it's great news all around. They're out living the good life, buying lattes made from the world's rarest and richest beans, and you get the satisfaction of knowing your advice may have helped them get there.

It's easy to attribute winners to the fact that the decade long equities bull market keeps continuing,   (which doesn't hurt)  but getting a profitable position is no guarantee. It can still be a grind to pick the right equity names, so it's natural to be excited when you're upside on a long position.

Unfortunately, keeping it that way can present its own challenges. Sure, your client could sell their winners and call it a day, but what if they aren't ready yet? Or, what if they have a non-qualified account and selling could create unwanted tax issues on the gains? That's why I want to mention ways for you to protect a long position; specifically, how you could consider using the options market to brew up a few ideas. You could also provide your clients with ideas around more flexibility through the income and potentially greater profits found through utilizing certain option strategies.

Before we get going though, let me remind you that even though The Options Industry Council advocates responsible use of options, these strategies and suggested ideas may not be suitable for all clients, nor may every firm or custodian even allow these trades to take place. Options do have risks, which are covered in detail in a document available on OIC's website, called Characteristics and Risks of Standardized Options. I've been fortunate to meet and talk with many financial advisors and RIAs over the years about options, and I always stress that options have to be understood before becoming part of clients' portfolios.

When options are allowed by your firm and a client has a balanced risk profile, they can be worked in to a blend worth considering. Although there are several strategies for clients with a defensive mindset, for this blog we'll focus on three that you can add to your advisory menu for protecting against drawdowns. They are:

  • Protective puts
  • Collars
  • Put spread collars

Let's look at protective puts to start.

A One-Option Option

Protective puts are a fairly straightforward concept. With a protective put, a client adds a long put to a long stock or ETF they already own. A single put would be the equivalent of controlling 100 shares. The protective put will require an outlay to initiate, but if the client's stock or ETF drops below the strike price of the put, they could either sell the shares at the strike to lock in that price, or sell the put, which likely will have risen in value because of the decline in the underlying. Note that if a stock or ETF is purchased at the same time as the put, this may be referred to as a "married put."

The protective put sometimes is described as similar to insurance, like that which you have on your house. It does take capital, but if things go against the client's underlying stock or ETF, they'll be glad it's there. Check out our OIC video on protective puts to learn more about this strategy.

Consider the Collars

Next, let's talk about the collar, a hedging strategy that includes the position we just went over,  the protective put,  while adding another position, the covered call. When your client deploys a covered call, they sell a call against 100 shares of a stock or ETF they own and collect the income, known as the premium. If the stock or ETF rises above the strike price, the underlying probably will be called away, but the client keeps the sale income. So in summary, the two-part strategy of the collar (sometimes referred to as a zero-cost collar) requires the sale of a call (short) and subsequent purchase of a put (long)  and the income from the covered call can offset some of the premium outlay for the protective put.

With a collar, the client has downside protection built in, although the gains for the underlying are now capped by the strike set with the covered call. It's a trade-off, which is usually the case with options. Still, it could make sense for the right client portfolio.

Now we're going to talk about a different type of collar, and it was recently described in detail in a new OIC study on option overlays. It's called the put spread collar. Like the standard collar, the put spread collar has a call sale, but instead of a single protective put, the put spread collar uses a bear put spread. With a bear put spread, your client is long one put and short, at a lower strike price, another put. That means your client has two income-producers, the short call and the short put, combined with the cost of purchasing a single long put.

As this is a three-option strategy, it may require greater sophistication than the two previous strategies we discussed. Also, certain firms may not allow this type of trading. However, if it is available, it's important to mention because you may oversee portfolios where this strategy could make sense.

So, as we get to the bottom of our cup this time around, let's summarize. I tell people that options are a bit like visiting your favorite coffee bar, you've got a lot of different blends, and you can always change it up depending what you need on that particular day. What's important to remember is that you can create what's right for your individual clients, whether they're looking for income or risk management, or both at the same time.

Do you have a topic you want to see covered in the Coffee With Cott blog? Let us know by writing to options@theocc.com. We want to hear from advisors like you with all your questions on options.

Options involve risk and are not suitable for all investors. Individuals should not enter into options transactions until they have read and understood the risk disclosure document, Characteristics and Risks of Standardized Options, which may be obtained from your broker, from any exchange on which options are traded or by visiting www.OptionsEducation.org. Any strategies discussed are strictly for illustrative and educational purposes and should not be construed as an endorsement, recommendation, or solicitation to buy or sell securities. Past performance is not a guarantee of future results. ©2019 The Options Industry Council. All rights reserved.

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