We’re almost nine years into this bull market. This means many of us own investments with significant unrealized gains, and we’d like to protect those profits.
One way to protect our profits is to sell the investment. Simple enough. But selling forces us to realize and pay taxes on all those gains. Besides, maybe we still like the stock for a variety of reasons and want to continue owning it. So selling may not be a great solution, but there is a strategy that can accomplish all our goals.
Buying A Put Option
Those who aren’t familiar with options might associate them with risky speculation. While it is true that options can be used to speculate, or essentially gamble, they can also be used to hedge your portfolio and dramatically reduce risk.
A buyer of a put option is simply buying the right to sell a specific asset at a pre-determined price (called the “strike” price) before a specific date. Think of buying a put option like buying insurance on your portfolio. In other words, the put buyer pays a premium to protect against a loss.
For example, let’s say you own Apple stock (AAPL). Today, AAPL is priced at $172 per share, but you bought 1,000 shares ten years ago for $20 per share. So you have $152,000 of long-term gains embedded in a position worth $172,000. Nice job. Now you want to protect those profits against a significant decline, but you still like Apple and want to continue owning it and don’t want to incur the tax liability yet. Well, one solution is to buy a put option.
Assume you’re willing to tolerate a 10% loss on the position. So you buy a put option contract that expires 6/15/2018 with a “strike price” of $165, which is 4% below the current price of $172. The strike price of $165 is the price at which you’re locked in no matter how much AAPL declines before expiration. The contract cost is the insurance premium. For this particular option, the premium is $8.25, or 4.8% of the position value ($8.25 premium / $172 share price). Therefore, your total potential downside is the 4% exposure (think of it like a deductible in an insurance contract) + the premium.
You proceed to buy the put option so now you’ve just locked in your price on AAPL at $165 no matter how low it goes before the expiration date. So even if Apple declines to $100 by that date, you’re able to “put” the stock (sell it) at $165, which means you saved $65,000 minus the $8,250 premium, or $56,750.
If AAPL is trading above $165 by the expiration date then the option contract expires worthless in which case you lose the premium of $8,250. However, if AAPL continued to run higher you were able to participate in that, continue to collect dividends and defer capital gains for another day / year. If AAPL rises 5% to $180 you participate, but the premium offsets that gain. That premium cost, of course, is the downside to buying puts because premiums can get quite expensive and eat into your returns.
Collar
Now, if you thought $8.25, or 4.8% of the position, was too steep a premium to pay for that six-month protection you could offset the cost of the put by selling call options at a strike price above $172. When you sell an option you receive the premium. This combo strategy of selling a call and buying a put around a stock you own is called a “collar.”
A call option gives the owner a right to buy the stock, which means the person selling a call option (“you” in this example) could be obligated to sell the stock at that pre-determined price (the strike price). So selling the call, although it produces a premium that can be used to offset the cost of the put, also caps your upside and may force you to liquidate your position before you’d prefer. However, capping your upside may not be an issue for you if you believe the stock may be “range-bound” for a while.
Covered Call
Another use for options is as an income enhancement tool.
Back to our example with Apple stock. You can simply sell (or “write”) a call on your Apple stock without purchasing the put option. In this case, you’re simply collecting and keeping the premium for selling the call option.
For example, you could write a call option that expires on February 16, 2018 with a strike price of $180, which is about 5% above the current price of $172. In return, you would collect $3,600 of premiums, which is over 2% of the position value ($3,600 / $172,000).
So not only do you get to collect any dividends paid in that two-month period, but you also get another 2% for the call premiums AND any appreciation up to $180. If AAPL exceeds $180 at expiration then your shares would be called away from you if you didn’t already close the option. The best case scenario for this strategy:
Over the two-month period you receive a $0.63 per share dividend + $3.60 per share for the call + $8 per share of appreciation. In other words, you’ll make $12.23 per share, or $12,230. That exceeds a 7% return in just two months! That’s over 50% annualized!
Now, remember, because you’re not buying the put options you don’t have downside protection like you had in the two other strategies described above. And, just like the collar described above, you are again capping your upside potential.
These are very basic explanations and not intended as recommendations. Very often, if you’re concerned about a position your best bet is to simply sell, but there are circumstances in which that may not be the ideal course of action. Always consult your advisors who thoroughly understand your goals and circumstances.
We’re just scratching the surface with options here as there are many other option strategies.
Please reach out if you would like help crafting strategies around positions with large unrealized gains or if you’re looking to enhance income from your current portfolio or improve your downside protection in the case of a market downturn.
