February 19, 2003

Want to Padlock Your Portfolio?
By John Brasher, CallWriter Publisher

With the wild market swings caused by the G-effect (geo-political uncertainty), it's anybody's guess whether to be long or short. The good thing about being long stock is that you make-a da' money when the market rallies. The bad thing is that you get hosed when the market drops. And a 200-point move in the DOW doesn't even raise eyebrows. Yes, there be risk any which way you go! So what's a stock buyer to do?

A penny SAVED is a penny saved!

Let's look at some alternatives for alleviating risk and see if there is a practical way to protect a stock portfolio.

1)  Just Say Stop.  You could set fairly tight stops on each stock so that you bail out of the position if it drops. The stop should be reasonable, related to recent trading highs or lows or to support levels. But there are a couple of defects in simply relying on stops. First, a volatile stock can trade in a wide range, and this can result in you getting stopped out of an ultimately profitable trade. One cause of losses is setting stops too tightly, because stocks really wallow nowadays. Second, what if the stock gaps down hard? It can trade right through your stop. Suppose you buy the stock for $20 and set your stop at a $17.75 major support level, but bad news causes the stock to gap down to $14? In this example, $14 is what you would get upon being stopped out - not $17.75.

2)  Cross Your Fingers.  We're not being (completely) facetious. This must be a valid approach to investing in stocks, since millions of investors do it, apparently. This is one of the chief ways that Wall Street picks your pocket. But we don't recommend it!

3)  Collar that Stock.  Yep, this is the point of the article. The way to "padlock" your portfolio is to establish a collar on each stock position. It protects you against a drop in stock price but also limits your profit potential, so it is a trade off. But in any market but a bull market, the collar makes a lot of dollars and sense. A collar is very simple. All you do is:

SELL a call option on the stock
  and
BUY a put option of the stock

Remember our option basics. The CALL option is a standardized contract that gives the holder the right to buy a fixed number of shares (100) of stock at a fixed price (the strike price) until the option expires. The PUT option is a standardized contract that gives the holder the right to sell a fixed number of shares (100) of stock at a fixed price (the strike price) until the put option expires. The option writer is the person who sells the option. Since each option covers only 100 shares, to cover 1,000 shares of stock, one would have to sell 10 call options. You buy a call if you think the stock is going up, and you buy puts if you think the stock is going down.

Example:  Let's use an example from this week's actual trading. Assume that you buy 1,000 shares of National Semiconductor (NSM) for $18.75, which has been as low as $9.95 recently. The market is turning bearish this week, bouncing off resistance, while the VIX is turning up. You're a little concerned about a pullback in NSM, and I don't blame you. After looking at your options, you decide to protect yourself by collaring the NSM position. So you do this:

Sell 10 DEC 20 Calls @$.75 =     $  750.00

Buy 10 DEC 17.50 Puts @$.75 = $  750.00

Net Debit or Credit                           -0-

The bid price of the 20 Call was $.75, and the asked price of the 17.50 put was also $.75, so you came out even on the collar. But because there are trading costs, you spent $50 or so to set up the collar. Nice move, though. You have now limited your total possible loss to $1.25, because even if the stock drops to $1, you can sell it to the put holder at $17.50, and he has to buy it. On the other hand, if the stock closes above $20 at option expiration on December 20th, you probably will be called out of the NSM shares and will only receive the $20 strike price, which would cap your profit at $1.25 per share.

The technique is simplicity itself. You simply sell naked puts on a stock you want to own. If you want to buy 1,000 shares, write 10 put contracts on that stock. Remember, a PUT is a standardized option contract that allows the put holder to SELL shares of a stock to the put writer at the strike price through option expiration day. So if you write a 20 Put on a $22.00 stock, the holder can put (sell) the stock to you at any time prior to expiration for $20 and you have to buy it at that strike price. But puts and calls are not usually exercised until expiration. Therefore, the holder will not put the stock to you unless it is below $20 at expiration. Below we look at a more thorough example.

Example: You want to buy Medimmune, Inc. (MEDI), which last traded during market hours on Friday the 15th at $24.02. The DEC 22.50 Put is bid at $1.75, which is approximately the price you could sell the put for. Assume that you want to buy 1,000 shares, which means that you would have to write 10 put contracts (10 x 100 = 1,000) to lower your cost on all the shares sought. So you write the 10 put contracts, for a total premium of $1,750.00. Remember, you don't have a dime tied up in the stock, but you have already put some nice change in your jeans! That put you just wrote will expire on December 20th, so let's look at the possible outcomes to you by option expiration:

1)  Stock price remains stable.  MEDI finishes the option period at $23.89, down just slightly. The put holder will not put the stock to you at expiration. Why would he? He has to sell it to you at the $22.50 strike price, but could get $23.89 by just selling it in the open market. Because the put expires worthless, you pocketed $1,750.00 in free money. No kidding, it is yours to keep. Now what? If you still like MEDI, sell some more puts! Think about this... if MEDI trades at a relatively stable price, you could sell naked puts on it month after month.

2)  Stock price goes up.  MEDI finishes up at $26 by option expiration. Same result as 1) above, you keep the $1,750.00. You might be thinking, "Doggone it, I made a $1.75 premium but MEDI has gone up almost $2, so I miscalculated." Not on your life! You didn't buy the stock, so you never had any capital tied up in MEDI, and it could have gone down. Because the put has expired, all trade risk is terminated and you are $1,750.00 ahead. So what if it went up? Sell another put!

3)  Stock price drops.  Now assume that MEDI has fallen to $21 by expiration and the stock is put to you at $22.50. Ouch, right? Nope! You're still ahead, because you had to buy MEDI at $22.50, but you got a $1.75 put premium, which lowers your net cost to $20.75. You're still in the stock at $0.25 less than current market. Now that the stock has been put to you (you wanted it, remember), you can decide whether to sell or hold it.

In other words, this strategy is a win-win. You either get free money or get paid to buy the stock you wanted anyway. And the premium you get for writing the naked put will reduce your cost to buy the stock. If the stock is not put to you the first month, you can write another, then another and so on until either the stock gets put to you or you change your mind about wanting the stock.

Margin. Most brokers will require a 20% margin on naked puts, meaning that you have to put up 20% of the stock's price when you write the put. So to write the above MEDI 22.50 put would require $4.80 per share in margin. Some brokers may require more of a margin percentage, especially if you are not experienced in naked writing.

Direction.  This is a neutral to bullish strategy that is relatively low risk, because it wins if:

• the stock price rises;
• the stock price stays the same;
• the stock price drops, but less than the premium received

Risk.  Your risk in writing a naked put is that the stock goes to zero. This will very rarely happen, but remember Enron, and many others. There are several ways to reduce the risk:

First, don't get greedy; only write puts on good stocks, like S&P 100 stocks.

Second, don't write naked puts during a market decline, wait for it to stabilize.

Third, write an out-of-the-money put, meaning that the put's strike price is less than the stock's current price.

Fourth, make sure the premium is equal to the difference between the stock's current price and the strike price, or as close as possible. Notice in our MEDI example above how the 22.50 strike was $1.52 out of the money, but we got $1.75 for the put. This way if the stock drops and is put to you, your portfolio will be even.

Spread that trade. Another way to significantly reduce your risk in writing naked calls (but also shave off a little profit) is to create a put spread. That is, instead of just writing naked puts, you would also buy a lower-strike put. In our MEDI example, instead of just selling naked puts, you could have created a put spread by purchasing the DEC 17.50 Put for $0.55. This would have lowered your maximum exposure to $5 per share. How? You are obligated to buy the stock at $22.50 if it is put to you, but by purchasing the 17.50 put, you can sell it to the 17.50 put writer and limit your loss to a maximum of $5 per share - the difference (or "spread") between the two strikes.

Here is how the bear put spread would work in the above example, assuming that the stock price dropped to $15 by expiration:

Sell DEC 22.50 Put                 $ 1,750.00
Buy DEC 17.50 Put                 $    550,00
Net Credit                            $ 1,200.00

Buy 1,000 shares at $22.50    $22,500.00
Sell 1,000 shares at $17.50    $17,500.00
Loss on stock sale                 $  5,000.00

Deduct premium received       $  1,200.00

Total Loss                             $  3,800.00

Ugly, right? Actually, it's beautiful, because you called the stock wrong or had a piece of bad luck, and the trade could have gone much worse. Had you just bought the stock at $24.02, you would have taken a loss of $9.02/share ($9,020), but the bear put spread strategy reduced the loss to $3,800. What if the stock went to $5? Your loss on the spread would be the same as illustrated above, no more. On the other hand, in possibilities 1) and 2) above, the spread would have dropped your total premium profit from $1,750 to only $1,200, but also would have significantly reduced your risk (and your margin requirement).

Now you know how to buy that special stock at a discount. If uncomfortable with this strategy, paper trade it first - meaning to set up trades only on paper and see how they do. This always is a good tactic when learning a new strategy.

Good luck and good trading!