In a bull market there’s a good chance that a stock that you have picked, using some selection process, will increase in value. This is what the average stock picker does, they buy stocks then hope (and often pray) that they go up.
Statistics show that in a bull market about 75% of the stocks will follow the general trend and go up, and in a bear market 75% will also go down. Trading with the trend is the best way to trade as 9 out of 12 stocks will follow the trend and give you the best chance of making gains on your stock purchases.
But what if you own some good stocks and don’t want to sell when the market is clearly going down, or about to go down?. There are a couple of tactics that you can consider, both of which involve the use of options, CALL options and PUT options. There is the widely known strategy called Covered Calls, and the much lesser known one called the Married Put.
Option trading can be very confusing and difficult at 1st, actually it’s not that complicated once you have had a good education in the subject. However if terms like Put and Call Option, Married Put and Covered Call don’t mean anything to you, don’t attempt to trade options until you get that essential education in the theory.
Call options are bought and sold in 100 share blocks, this is 1 option contract. When doing a covered call you sell 1 call option contract for every 100 shares that you own. The value of the call option will go down if the stock goes down, giving you the chance to either let it expire worthless or buy it back at a much cheaper price. Either way you can get about 4-6% downside protection, but if the stock decreases more than this then you will have to take a loss.
The big problem with the covered call strategy is that it only provides very limited downside protection and if the stock takes a big cut like 25%, which can happen, you lose big time and only recover about 3-5% of the loss.
There is a much better way to protect stocks in a bear market than using covered calls, it is called the Married Put. Instead of selling a low credit call option we buy a Put option which can provide a large amount of downside protection. The Put can rapidly increase it’s value as the stock goes down, by how much depends on how carefully the Put option has been selected. The Put is matched to the stock like a good marriage for the best results.
There are a number of parameters that need to be considered when creating a Married Put for protection, the following list highlights the main points:
1. What strike price is selected for the Put option
2. The price of the stock
3. Choice of options, in or out of the money
4. Time to expiration of the Puts
The last point is very important because the Put options that you buy only have a limited life and you need to consider for how long you need the protection. The big advantage of the Married Put strategy over the Covered Call strategy is that if selected correctly it can provide 90-95% loss protection in the event of a large drop in the stock price.
The cost of the PUT is a disadvantage of this strategy if you take a shortsighted approach. There are ways of offsetting this option cost when this strategy is taken to the next level. When traded correctly, with the right stock, the expense of the Put can be offset and good returns can be made when others are loosing their shirts.
The general idea of the Collar Trade is to combine the covered call and married Put strategy into one, this is what is called the Collar Trade. In effect you put a collar around the stock, sell a call and buy a PUT. If you do this correctly most of the cost of the Put can be offset by the credit from the covered call so you can protect your valuable stock at almost no cost. Yes this is a great strategy which the general public is unfortunately very ignorant of, and most brokers don’t understand.