This is a guest post written by Mark Wolfinger of the investing blog Options for Rookies. Mark grew up in Brooklyn and in an earlier life, earned a PhD (chemistry) from Northwestern. After several years as a research chemist, in Dec 1976 he moved to Chicago to trade options. Over the next 23 years, he was primarily a CBOE market maker, but also worked as a risk manager, and coached new traders. He left the CBOE in 2000 and began a career as an educator. He’s published three books and numerous magazine articles.

Mark recently authored The Rookies Guide to Options and he approached me with a novel guest post idea. You dont normally associate options with passive investing but he is going to explain how you can use options, specifically collars, to protect yourself when passive investing.

Let’s begin by agreeing:

• a) Passive investing beats active investing for all but the few talented traders who consistently outperform the markets. Let’s also agree that none of us is a member of that elite group.
• b) The rules: allocate assets, diversify, buy and hold, don’t panic by selling into market declines etc. These are the most commonly used methods to minimize investment risk. They are constantly repeated by journalists, bloggers, brokers, financial planners and financial advisors.

Should most of us follow this advice with confidence? Do we save a portion of each paycheck, invest passively, and confidently accept whatever happens?

I vote ‘no.’

I ask: Why own an investment portfolio that’s unprotected against loss? Why allow your financial security to be threatened by severe market declines? Sure, the market is likely to trend higher over the years, but why take that chance?

Today’s investors can do better. Times change: stock is the core holding of almost every prudent investor’s portfolio, yet only 100 years ago the idea of owning stock would have been considered lunacy. Today, new investment tools are available, and professional advisors ignore them. You can’t blame them for protecting themselves. Offering sound, but not universally accepted, advice that may result in lost money is an invitation to a lawsuit.

Where Options Fit In

Options were created as risk-reducing tools and can be used to protect your investment portfolio against significant loss. Consider a single option strategy – the collar. As passive investors, assume that the stock market portion of your portfolio consists of ETFs (please: do not buy 2X or 3X ETFs because they do not perform as advertised) that mimic the performance of specific broad based indexes, such as SPY (S&P 500) or IWM (Russell 2000).

Assume you own 100 shares of SPY, currently trading near 107. That investment is worth $10,700.

If you buy one SPY Oct 105 put, you get the right (that expires on the 3rd Friday of Oct) to sell 100 shares of SPY at 105 (the strike price), no matter how far SPY declines. Ignoring the cost of the put for now (it’s about $140), your losses are limited to $200 in this example (pay 107, sell 105). There’s nothing special about this put and you can buy a put with a different strike price or expiration date.

To complete the collar, sell one call option, which gives someone else the right to buy your SPY shares at the call’s strike price. You collect cash when selling the call – and you can easily arrange for this cash to offset the cost of the put, giving you the collar for approximately zero out of pocket cost.

If you elect to sell the SPY Oct 109 call, you accept the obligation to sell your shares at 109 – but only if the call owner chooses to exercise his/her rights. Obviously your maximum sale price (109) limits potential profits.

You can own this per collar for no cash (call priced a few pennies higher than the put). You are guaranteed that your position cannot lose more than $200 and that your profits cannot exceed $200 as long as the collar is in place.

Collars are flexible and provide alternatives:

• a) To possibly make more money on a rally, sell calls with a higher strike price. The collar costs more because you collect less cash for the call.
• b) If you prefer to pay less (or even collect cash) when establishing the collar, choose a call with a lower strike price.
• c) Buy a put with a higher or lower strike price. That’s similar to changing the ‘deductible’ on an insurance policy.

Are collars for you? They’re not for everyone, but owing passive investments with no chance of incurring large losses, coupled with the opportunity to grow your account over the years – that works for me. The problem is that not everyone is willing to accept a limit on potential profits, nor is everyone willing to be a hands-on investor (trades can be made monthly, quarterly, annually). Don’t trust any financial advisor to makes these trades for you -at least not until collars are more widely recognized as tools for the Prudent Investor.

How well do collar perform compared with buy and hold? Recent data says better than expected.