There are lots of cases where you can have a positive view of a stock, but still want a bit of investment protection. A fairly typical way of getting some protection against a drop in price is to place a
stop-loss order with your broker, so that if a stock hits a certain price that you set, the broker will automatically sell the stock. This limits your loss (known as downside protection), and if the price doesn’t go down, then you keep all the stock, and you get to take full advantage if the price goes up (known as upside participation). Also, it should be free to place a stop-loss order with your broker, unless the price is hit and the stock is sold. So, stop-loss orders have three benefits: downside protection, upside participation, and no up-front cost.
Unfortunately, there are a couple downsides (no pun intended) to stop-loss orders. The first is that if a stock is really plummeting (there aren’t any buyers at all), then it may be difficult or impossible for your broker to get the price that you’ve specified. That’s sort of an extreme situation though and only happens about once every thirty years (think
October 19, 1987). The other, much more likely, scenario is that the stock goes through a temporary decline (causing your stock to be sold), but then recovers. In that case, you’ve sold for a loss and you miss out on the recovery.
So instead of placing a stop-loss order with your broker, you can purchase what’s called a
protective put. A “put” is a contract that says the buyer of the put has the right (not an obligation; it’s the buyer’s choice) to sell stock on (or before, in most cases) a predetermined day at a predetermined price to the person who sold (”wrote”) the put. For example, today RHAT closed at $23.22; you can buy an option to sell 100 RHAT shares at $22.50 (the strike price) anytime between today and November 18, 2005 (the option expiration date) for $55 (as reported by
Yahoo!). So you get downside protection and full upside participation, for a price. (There’s also a
married put, which is the same thing as a protective put, except you buy the stock at the same time as the put; a protective put implies that you already own the stock.)
But there is still the annoying up-front cost. If you’re willing to risk missing out on some of the potential upside though, you can offset the costs. A
collar is when you buy a protective put and at the same time selling a call option. By selling (writing) a call, you give someone else the right (again, not the obligation) to buy shares on a predetermined date for a predetermined price. For example, say you do buy the protective put above, and at the same time, write a call option for 100 RHAT shares that expires on November 18, 2005 for a strike price of $25. The proceeds from this sale will be $30 (again, minus fees). So for a cost of $25 ($55 to buy the put minus $30 to write the call), you’ve got downside protection, and upside participation up to about 7.7%.
All of this assumes that your preference is to keep the stock. But say that your stock has done very well and it’s gotten to be a sizeable part of your portfolio, and you’d like to diversify a bit. That means that you’re serious about selling it, regardless of what you think the price is going to do. (There are lots of good reasons to sell a stock that’s enjoyed nice gains, not the least of which is that nice gains are generally caused by nice growth, and a company can only grow so big.) Selling the stock outright is one technique; another is a variant of
dollar-cost averaging, but instead of buying a fixed dollar amount, sell a fixed number of shares. But you can combine either of these with writing call options to potentially achieve even better results.
A
covered call is when you own a stock and write a call option on it (like a married put, a
buy-write is when you buy the stock and write the call at the same time). Instead of selling the stock immediately, you give someone else the option to buy it from you at a predetermined future date. Because the date is in the future, there’s a bit of a premium that buyers will pay (which means more money for you). For example, November 18, 2005 calls for RHAT with a strike price of $22.50 are selling for $120 for 100 shares; that means that if the option is exercised, you make $22.50 from the sale, plus $1.20 per share from the option, for a total of $23.70 as your effective sale price. If the option is not exercised though, then your shares are not sold, but you get to keep the $120, and do the whole thing over again.
(Unfortunately for me, Brocade has a company policy prohibiting collars and covered calls. But fortunately for me, I don’t own very much BRCDE stock.)