Insuring a Value Stock Against Downside Losses, at No Cost

This article offers at a different approach to improving the risk and reward profile of a value stock.

In previous articles, I’ve written about protective puts (sometimes called married puts) that you can use like an insurance policy. If the price of your stock goes down, your loss exposure is eliminated or reduced. I’ve also written about earning extra income from a stock, preferably one that’s growing slowly, by selling covered calls.

In this article, we’ll combine a protective put and a covered call, in what’s known as an option collar. We will configure the put and call options in such a way that there is no cost to buy the insurance (more information about puts, calls and collars can be found at the end of this article).

The Stock

F5 Networks Inc. (FFIV, Financial) currently has places on both the Undervalued Predictable Screener and the Buffett-Munger Screener at GuruFocus. It is a tech company, or as it describes itself in its 10-K for fiscal 2015, “F5 Networks is the leading developer and provider of software-defined application services designed to ensure that applications delivered over Internet Protocol (IP) networks are secure, fast and available to any user, anywhere, anytime, on any device and on any network. Our core technology is a full-proxy, programmable, massively-scalable software platform called TMOS (Traffic Management Operating System).”

Price and Environment

On Aug. 25, the company had a share price of $124.39 and a 10-year price history that looks like this:

It is immediately obvious that FFIV is approaching a resistance level (as the technicians would say), and the share price will likely do one of two things:

• Continue its upward progression and set new highs (relatively new highs), or
• Turn around and head back down again as it has numerous times in the past.

Experts may have opinions about its future direction, but let’s assume we have none, and act accordingly.

Our Goal

In this paper trade, our first goal will be to preserve our capital. We will be pleased if the shares increase in value, but want to limit our potential losses as much as possible.

While we’re prepared to spend a small amount for protection, we would prefer to spend nothing.

Finding Collar Options

The information we need to construct a collar is contained in the option chains (tables), which show up in the listings of most major online portals, including Yahoo! Finance and Google Finance. Here’s what the first few lines of the FFIV option chain for January 2017 look like at Yahoo! Finance:

Note the Bid and Ask prices. Bid is the price you can expect to receive when you sell, and Ask is the price you can expect to pay when you buy. Needless to say, Ask is always higher than the bid (except for the odd anomaly) and a market maker collects the difference between the two prices.

The second way to find a collar comes from OptionsProfitCalculator.com. In addition to prices, it can project what you might expect of the put and call prices when the stock price changes and over time. This image shows the profit/loss profile for a $125 put / $130 call configuration for the Jan. 20, 2017 expiry:

Note that you can click any cell in a live matrix to see the put and call values.

A third alternative for finding a collar is a pay-subscription service called Power Options. It offers more information than the two free services above, including Maximum Risk and Maximum Return:

Note that all four collars shown here offer a positive net premium. In other words, the covered call brings in more cash than you would spend to buy the put. The image above shows just four of the many combinations available, some of the others are negative net premiums.

We can further visualize the maximum risk using a table format:

Let’s look again at the image from Power Options and review the information in the first row:

• Call Option Expire/Strike & Days to Expiry is a descriptive column, with the call option strike, expiry date, and number of days until expiry listed;
• Call Bid Price: the dollars and cents we would receive for selling one unit of this call (calls and puts are always bought and sold in contracts of 100 units);
• Put Option Expire/Strike & Days to Expiry is also descriptive, with the put option’s strike, expiry, and days to expiry;
• Put Ask Price: the price we would have to pay to buy one unit of this put option;
• Net Premium: the amount by which the call price exceeds the put price; if the net premium was negative it would show by how much the put price exceeds the call price;
• Max Risk: the maximum amount you could lose with this collar, stated as a percentage;
• Max Return: the maximum amount you could gain, in the best case scenario;
• % If Unchanged: what the yield outcome will be if the FFIV share price is exactly the same when the collar expires in January;
• % Probability of Being Assigned: there is a 48.7% chance the price of FFIV will be above the $125 strike price when the collar expires; if above $125, we would have to turn over the stock, or roll it (buy back the call and sell a new call);
• Earnings Date: covered call writers try to avoid selling calls during months when there is an earnings report; in longer term positions, holding through earnings dates is unavoidable;
• % If Unchanged Annual: Converts the % If Unchanged (described above) into an annual return or loss;
• Call BS Ratio: the Black Scholes ratio for the call option; a ratio above 1.0 indicates the option is over-priced and a ratio below 1.0 indicates under-priced;
• Put BS Ratio: the Black Scholes ratio for the put option; a ratio above 1.0 indicates the option is over-priced and a ratio below 1.0 indicates under-priced.

Those are the details for one of many potential collar configurations. There are probably a dozen more that deserve serious consideration, and literally thousands of potential combinations that are just too far from the current share price to make any sense.

Further, there is no one right or wrong choice. Rather, there are multiple choices, allowing us to pick one that best reflects our individual needs, including our risk tolerance and the amount we're willing to pay.

Conclusion

We’ve seen in this paper trade it is possible to protect the downside of a volatile stock, without being out of pocket. The call option brought in enough cash to pay for the protective put, and leave us with $100 ahead on the contract.

Of course, there’s about a 50/50 chance (see % Probability of Being Assigned) that the share price will be above the strike price of $125 at expiry. If that turns out to be the case, we might roll out the call option, roll it up, or both. Personally, if this were a real rather than a paper trade, I would probably configure the collar so the share price had more room to grow, perhaps a $130 or $135 call.

Do option collars work in the real world? From personal experience, I can tell you they do. In an earlier article, I described how protective puts saved me when Herbalife (HLF, Financial) plunged, in response to Bill Ackman (Trades, Portfolio)’s announcement that he was taking a massive short position against the supplements company. Another example that comes to mind is a small, highly volatile pharma company that traded up and down between $4 and $20. After about six months of buying and selling options on the stock, I closed out with a 50% gain; the key to that was minimizing losses (with puts) when the stock price collapsed or declined, which it did several times.

More on Options

In the world of stock options, there are puts and there are calls. Both puts and calls can be bought and sold; this is our starting configuration:

We go through this process when setting up a collar:

1. We buy a stock for which options are available
2. We buy a protective put that puts a floor price under the stock
3. We sell a covered call on the stock.

In terms of cash flows:

1. We spend money to buy the stock
2. We spend more money to buy the put
3. We receive money for selling the call.

In the world of options lingo, this configuration is called a Collar (so called, because the options go around the stock like a shirt collar goes around your neck). You’ll find many options have colorful names; don’t let them distract you from their functions (often the names have some kind of descriptive value).

You may have heard that options, whether puts or calls, are dangerous tools, and should be avoided at all costs. That’s only slightly true. Yes, you can dangerously leverage yourself with options, but with even a modicum of education, you should be able to use them to reduce risk, rather than increase it.

And, that’s our goal, to at least partially de-risk a stock. It’s particularly useful strategy for value stocks, which may not have completely recovered from the issues that caused their share price to drop in the first place.

Put Options

Think of a protective put as an insurance policy for your stock or stocks. You pay a premium when you buy a put, as you would to an insurance company. In return, the party who sold the put (received your premium), guarantees to buy back the put at the strike price on which you both agreed.

If the price of your stock is below the strike price at the contract’s expiry date, then you have the right to put the stock to the other party for the previously agreed price (all of this is done automatically through your brokers and an options clearing house).

That’s the theory; in practice you can just sell your put back into the options market. The put option’s value will have increased as the price of your shares has gone down (but not necessarily on a one-for-one basis, an issue we’ll tackle in another article).

So that’s the first half of the collar strategy, reducing or eliminating our risk. We can go further than simply de-risking, though. Our aim was to use a call option to pay for the put option.

Call Options

To offset the cost of our puts, we will sell what are known as covered calls. First, selling a call option on a stock is similar to selling an option that would allow someone else to buy your house in the future. With neither you nor the other party knowing what the price of your house will be in a certain number of weeks or months, you negotiate a price that reflects your willingness to sell at particular prices, and the other party’s willingness to buy at those price points. Call options live in a much more liquid market, and transactions take place between anonymous players, in a process intermediated by a company called a market maker.

One more piece of important information: the covered in covered calls. When you sell a call, you’re guaranteeing you will make the stock available at a specific price on a specific date. If you already own the shares, you’re covered and its no problem to be called out of the stock. If you sell calls without the underlying stock, then you are selling naked. You will have to buy the stock at a price that is at or above the strike price, and could be well above the stock price. Selling naked, then, could be a disaster and should never be done by anyone but an experienced professional.

In conclusion, you can reduce or eliminate downside risk when you buy or own stocks. And, if you can make a collar work, you may get that downside protection at little or no cost.

Disclosure: I do not own shares in any of the companies listed in this article, nor do I expect to buy any in the foreseeable future.

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