So what’s the best strategy for a declining market?
For most self-directed investors, buying put options is the answer. Unfortunately, this strategy is one of the worst ways to protect the stocks in your portfolio right before an earnings announcement.
These misinformed self-directed investors yield to the assumption that when a stock or index is falling, volatility increases, thus benefiting the long put position. This is certainly an added benefit to the long put strategy under normal market conditions.
However, post-earnings moves can actually be met with a decrease in volatility, regardless of the direction of the stock following the earnings report. With that being said, always use caution when trading just ahead and through the earnings report of your stock of choice. This type of result is the reason why many newbie options traders are disappointed when they pick the direction correctly after an earnings report but still suffer a losing trade.
Implied volatility is pumped up before an earnings announcement, thereby inflating the price of an option. It makes perfect sense, because the demand for puts are typically greater before earnings. And we all know that higher demand translates into higher prices, regardless of what is being sold.
However, coupling a long put with a covered call provides the ultimate protective strategy, especially when you’re concerned about your stock heading into earnings. This strategy is called a collar:
Collar = (long stock + short call + long put [with different strikes])
To build a collar, the owner of 100 shares of stock buys one put option, which grants the right to sell those shares at the put’s strike price. At the same time, the stock holder sells a call option, which grants the buyer the right to buy those same shares at the call’s strike price.
Because the investor is paying and receiving premium, the collar can often be established for zero out-of-pocket cash, depending on the call and put strike prices. That means the investor is accepting a limit on potential profits in exchange for a floor on the value of their holdings. This is an ideal trade-off for a truly conservative investor.
Moreover, the results of a new study examining the use of options in a collar strategy on thePowerShares QQQ (NASDAQ: QQQ) demonstrate that a collar strategy provides superior returns to the traditional buy-and-hold strategy, while reducing risk by almost 65%.
“Loosening Your Collar: Alternative Implementations of QQQ Collars,” by Edward Szado and Thomas Schneeweis, looked at data from March 1999 to May 2009. The study concluded that over the entire 122-month period, the collar strategy returned almost 150%, while QQQ lost one-third of its value.
Additionally, the study simulated a collar strategy on a small-cap mutual fund. The return of the mutual fund collar was four times the return of the fund, while the standard deviation was about one-third lower.
Options have become a necessity for the self-directed investor, and the aforementioned studies prove the importance of integrating them into your portfolio. Don’t allow yourself to miss out on what is the future of investing for the self-directed investor.