Well that is a question that almost everyone seems to have on their mind right now with stocks making all-time highs again.  This is the third test in the last month or so.  Could this be the one that puts us over the top and creates a new rally with renewed power?

Today I want to talk about a way to consider buying this rally while still keeping a form of risk management in place.  This article will be about the knock-out collar.

First, let’s set the stage for a stock you may like in this market.  Let’s say it is currently trading at $50/share.  Also, let’s say that this is a stock that you like at 50, but would love at 45.  If this is a situation that you find yourself in, this strategy may be something to consider.

Step 1 would be to buy the stock at 50 and sell at 55 covered call.  The time frame can typically be from 1-3 months.  However, every stock varies.  The idea is to get enough premium to cover the cost of the put spread I’m about to discuss.  For purpose of this example, we will collect $1 for the covered call.

Step 2 would be to buy a 50 put for $2.  At this point in the trade, you have spent money to buy the stock, and you are also at a debit from your option trades as you did not get enough premium to cover the cost of a single leg put option ($1 credit for the call, $2 debit for the put).  That leads us to step 3….

Step 3 is to sell a 45 put for $1.  By doing that, you set up the trade to be net even money.  That means that there is no cost for this trade (except commissions).

Keep in mind that trade almost NEVER work out this simple.  You will likely pay a small debit for the trade.  I have seen this set up for credits, but it is rare.

What is the benefit?  The benefit is that you get to have exposure to a stock with protection from a 10% loss.  In other words, if the stock goes down, you can exercise your put option to sell the stock at 50 (your purchase price).  Of course if it goes below 45, the person you sold the 45 put to will exercise their option to sell it back to you at 45.  So, the way to think if this benefit is that you can have protection from 50 to 45 on this trade (a 10% loss). 

Also, it is important to note that this and all my examples in this article are assuming you hold the stock and options until expiration.  That doesn’t happen often in the real world.  However, it works great for helping to understand a concept of a trade which is what we are trying to do here.

What is the drawback?  The main drawback is what we already discussed.  That is that you will NOT have any protection below 45.  Since this is a put spread, the protection is limited.  The other drawback is that you will have no upside past 55.  Since we sold a covered call, there is someone on the other side of the trade who can call us away at 55.

The bottom line is that you have the opportunity to have a 10% buffer of protection if you are willing to give up upside AFTER a 10% move higher.  These numbers won’t always match up to this description (as it depends on the stock, volatility, etc.), but it is a tool to consider in these markets that are at all-time highs.

If you’d like more information on this or other strategies I do for myself and my clients, please email me at mtosaw@stcharleswealth.com.