For some active traders, earnings season represents more of a casino, with the possibility of immediate jackpots off of the large stock price moves that often immediately follow a report. But for the majority of investors, these knee-jerk spikes are viewed as potential minefields they would just as soon avoid.
The quarter-to-quarter focus and large single-day price moves can be major obstacles, both financially and mentally, to maintaining a rational long-term approach to investing. Instead of taking time to really assess the company’s results, a sharp decline could trigger an emotional response that causes one to dump shares on what might only be a knee-jerk overreaction.
Think of IBM’s
(NYSE:IBM) $11 or 6% decline following its earnings report yesterday. Two months from now, shares under $200 might look like a bargain. But for someone already long the stock, adding to the position yesterday, today, or even tomorrow not only takes fortitude and conviction but also takes the financial wherewithal.
How nice it would be if you could essentially put your position on hold, make a patient and thoughtful analysis of the earnings report, and then step into the fray with a clear head. By using an option collar, one can do just that.
A collar is a position consisting of long stock, long put, and short the call. The sale of the call helps finance the cost of the put, meaning that this is a low or even no-cost position. The strategy is typically used to lock in a minimum sale price on an existing long stock holding. This can help you ride out the short-term blips and dips that earnings can generate.
With popular names such as Google
(NASDAQ:GOOG) reporting this afternoon, McDonald’s
(NYSE:MCD) reporting tomorrow, and Apple
(NASDAQ:AAPL) reporting next Thursday, using a collar to put these positions on hold for a few days around earnings could keep you from getting rattled out of what should be long-term core holdings. [Editor's note: After this article was published, Google's filed its 8-k financial statement early and showed a large miss on profit targets. The stock plunged $68.19/share, or 9.03%, and trading was halted.
Let’s look at how a collar in IBM might have worked. On Tuesday, with IBM trading at $211, one could have set up a collar as follows:
Bought an October $210 put for $2.70 per contract.
Sold an October $210 call for $3.50 per contract.
The sale of call would give you the obligation to sell shares at the $210 strike price; the purchase of the put gives you the right to sell shares at $210 any time prior to this Friday’s expiration. So given the position was established for an $0.80 credit, you have basically locked in a sale price at $210.80 per share between now and this Friday’s expiration. A look at prices today show that with shares trading $199, the call is $0.03 and the put is worth $11.30. This means that the $12 decline in the stock has been offset by the decline in the call value and the increase in the put value.
You could now decide if you want to let options be exercised at tomorrow’s expiration and close out your IBM position at an effective sale price of $210.80. But more likely you would want to just close out the option collar and maintain your long, dividend collecting, share position, none the worse for wear.
Of course, it also important to note that had shares of IBM rallied 5%, those gains would have been forgone. But again, the collar could simply be removed and the long stock position would be maintained as if nothing happened.
Now let’s take a quick look at some potential collars in the names mentioned above. With Google trading around $750, one can sell the $755 calls that expire next Friday, October 26 at $17 and buy the $745 puts for $17 per contract. This means that this is established for even money. Note that in this case, I’m using different strikes for the puts and calls which both are slightly out-of the-money . This is simply to illustrate how you can address strikes to give a bullish or bearish tilt. In this case, you are locking in a sale price of either $755 on the upside or $745 on the downside. So you are risking $5 to possibly make $5 should Google move above $755 following the earnings report. Using next week’s expiration gives you several days following the report to assess your position.
Likewise, with Apple due to report next Thursday, one may look at the options that will expire the following week on November 2 (they will be listed that prior Thursday, October 25) or even go out to the November series.
Collars are a great solution to help steady your portfolio during the jittery earnings season and let you make a rational and patient analysis of the earnings data.
No positions in stocks mentioned.
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