Singles and Doubles Add Up to a Winning Strategy
Last Tuesday, shares of Biogen (NSDQ: BIIB) jumped 26%, from about $223 to more than $281. The company reported a strong quarter. Additionally, it very surprisingly announced that it was planning to submit an Alzheimer’s drug for FDA approval. Previously, the company had given up on the drug, but new data suggest there could be a chance for approval.
On the other hand, the BIIB 10/25/19 $270 put went from $46.75 to $1.83. That’s a 96% loss.
If you had a position on either side of these trades, you will probably remember that day for a long time.
Don’t Let One Loss Wipe Away Profits
While days like that are memorable, they are rare. You can’t count on smacking one out of the park with every at bat. If you take big risks all the time, a big mistake or two could wipe out your profits. Successful option traders make money by consistently hitting singles and doubles and minimizing the big losses.
For experienced investors, this means not only trying to profit through options, but also protecting your stock positions. One of the simplest but effective ways to do this is through a protective collar.
A Simple Example
Let’s go back to Biogen and use that stock as an example of how you might protect your profits.
Let’s say you bought 100 shares of BIIB last month at $230. You are very happy at the price jump. At Friday’s ending price of $288.04, you have about $5,800 in profits.
You know the stock will likely rally if an FDA approval looks more and more likely. But you also know that the Alzheimer’s drug data isn’t that great and potential bad news will send the stock price crashing.
Basically, you don’t really want to sell the stock now, but you also want to protect your profits.
How to Protect Yourself
In this case, you can sell a call and buy a put with the same expiration date to form a protective collar. For the call, pick a strike price at which you would be happy to sell. For the put, pick a strike price that caps your maximum loss at a level you would be happy with.
At real market prices as of last Friday, you could sell a January 17, 2020 $300 call for $14 and buy the same-date $285 put for $16. You have a net debit of $200 ($2 x 100).
(Major brokers like Schwab and TD have drastically lowered/eliminated commissions lately. The commission cost is tiny and I am not counting it.)
You have gotten yourself protection for your BIIB shares. You guaranteed yourself the right to sell BIIB at no less than $285. You have capped your maximum loss at $500.
Limit the Maximum Downside
Why is it $500?
As mentioned, BIIB ended Friday at $288.04 (let’s just call it $288 to keep things simple). Because you have the right to put your shares to someone at $285, the maximum you can lose between last Friday and January 17 is $3 per share. Since you have 100 shares, that’s $300. Add on the $200 debit for opening the protective collar, and you get the $500 total.
No matter how far BIIB falls by January 17, you will lose no more than $500, or 1.7% ($500 out of your $28,800).
On the Other Hand…
The downside is that you have also capped your maximum gain at $1,000.
Since BIIB will get called away if it rises above $300, your maximum gain between now and January 17 is $12 per share. Multiply that by 100 and subtract the $200 debit.
If the stock price ends up between $285 and $300 at expiration, both options will expire. If you want to continue to extend protection, you can start another collar. Or if you expect some FDA news and don’t want to limit yourself on the upside, simply buy a put without selling a call.
But maybe you’re looking for safer ways to beat the market. That’s why you should turn to my colleague Jim Fink, chief investment strategist of Options For Income.
Jim is a veteran investor who made millions for himself. Now, he wants to share his secrets. Jim can show you a quick, simple trade that pays off in a big way, every Thursday. It’s sort of like getting an extra paycheck. Jim also can point to scores of satisfied readers who made huge profits following his advice.
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