1 Way to Protect Your Gains

When Tennyson wrote " 'Tis better to have loved and lost, than never to have loved at all," he wasn't speaking about stock market losses.

But as many investors can attest from our roller-coaster experiences over the past few years, sometimes it's better to have kept it all in cash than to have watched gains evaporate.

Indeed, a number of behavioral studies have found that humans experience more pain from our losses than we experience pleasure from our gains. And that phenomenon -- what researchers call loss aversion -- can lead to bad investing habits like chasing returns, selling prematurely, or, worse, being too scared to invest at all.

Fortunately, there's a way for us to enjoy our gains, reduce downside risk, and not spend a dime out of pocket to do it: an options-based strategy long used by money managers to handle their clients' profitable positions called a "cashless collar."

How does it work?
Let's start with an example. Say you purchased 100 shares of Apple back in 2006 for $53 per share and it's currently trading for $325 – an incredible 513% gain. Now what to do? You have several choices, the more popular of which are:

  1. Hold on tight and hope for even more gains.
  2. Sell immediately and pocket the profits.
  3. Place a trailing-stop sell order.
  4. Buy a protective put option.

While each of these four strategies has merit, they also each have substantial risks.

Strategy

Pros

Cons

Hold and hope

Enjoy theoretically limitless upside.

Stock could fall sharply and you lose most -- if not all -- of your gain.

Sell now

Cash in your pocket.

Creates significant taxable event; miss additional upside.

Trailing-stop

Reduce downside risk.

Stock could fall temporarily to your sale price and then recover sharply.

Protective put

Secure a price floor.

Costs money out of pocket -- could lose all of it if stock rises.

A less popular -- but more effective -- choice is the aforementioned cashless collar. Here you buy a protective put (ideally about six months out) at a price below the current price and simultaneously write a covered call option expiring in the same month at a price above the current price, thus establishing a range or "collar" around the current price. The proceeds from the sale of the covered call finance the cost of the protective put, hence the "cashless" part of the strategy.

Painting the picture
In the case of Apple, then, it might look something like this:

  • Current price: $325
  • Buy one April 2011 $310 put for $14.30
  • Sell one April 2011 $340 call for $15.15

So while you pay $14.30 per share ($1,430 per contract) for the price floor of $310, you simultaneously receive $15.15 per share ($1,515 per contract) to establish the upper limit of $340. In fact, in this scenario you actually get paid -- better than "cashless" -- $0.85 per share ($85 per contract) to enter into this arrangement through April 15, 2011.

Let's consider the potential outcomes:

If ...

Then ...

Apple is between $310 and $339.99

Both options expire worthless. You hang onto your shares, can enjoy any small upside, and the $0.85-per-share credit is yours to keep, too.

Apple plummets to $90

Phew. You exercise your right to sell the shares at $310; the covered call expires worthless.

Apple falls modestly to $300

Decision time. You can exercise your right to sell the shares at $310 or if you'd rather hold on to your shares, you can choose to do nothing and also keep the $0.85-per-share credit.

Apple surges to $500

Least-ideal scenario. Since you've "capped" your sale price at $340, you're missing out on the upside.

As you can see, the biggest risk to a cashless collar is that the stock surges well above your upper limit and you're locked out of enjoying those gains.

The key to managing that risk is prudent business valuation, for if you have an idea of the company's true value, you'll be more comfortable selling at the higher strike price.

Other worthy candidates
The following stocks all sport forward price-to-earnings ratios above the S&P 500 average of 14.5. If you've enjoyed outsized gains with any of these stocks over the past year, a cashless collar could be well worth considering.

Company

1-Year Price Change

Forward P/E

Netflix (Nasdaq: NFLX  )

216%

50 times

F5 Networks (Nasdaq: FFIV  )

157%

39 times

Cummins (NYSE: CMI  )

138%

16.9 times

Huntington Bancshares (Nasdaq: HBAN  )

90%

16 times

American International Group (NYSE: AIG  )

81%

16.9 times

Abercrombie & Fitch (NYSE: ANF  )

67%

24.6 times

Caterpillar (NYSE: CAT  )

65%

17.5 times

Source: Capital IQ, a division of Standard & Poor's. Data current as of Dec. 30.

Could these companies go much higher from here? Possibly, but investors in these stocks will have to ask themselves if the potential upside outweighs the downside risk. If the answer is yes, then a cashless collar may not be ideal, but if the answer is no, it's time to look more closely into a cashless collar strategy.

Foolish final word
Done correctly, a cashless collar can provide you with peace of mind on a profitable position and still maintain sell discipline. And best of all, it can be implemented with no out-of-pocket cost.

While this isn't an everyday strategy, it's worth understanding as another tool to help successfully manage your profits.

If you'd like to learn more about our strategy at Motley Fool Pro, where we use stocks, exchange-traded funds, and options to both long and short the market, simply enter your email address in the box below.

This article was originally published Aug. 3, 2009. It has been updated.

Fool analyst Todd Wenning can't wear turtleneck collars because his head's too big. He does not own shares of any company mentioned in this article. Apple and Netflix are Motley Fool Stock Advisor picks. The Fool owns shares of Apple. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


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Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On December 31, 2010, at 3:09 PM, Camsteerie wrote:

    This is a good article, however I potentially see a problem which may or may not exist.

    When using discount brokers, Protective Puts and Covered Calls (Cashless Collars) are not an option in their drop-down list for trades. Now I may be creating a problem where there isn't one in that a simple Put and Call may accomplish the same thing. Are we just using fancier terms for a common action?

  • Report this Comment On January 17, 2011, at 9:33 PM, boboh7 wrote:

    Color me a neophyte at investing, but if the big risk of the above method is losing out on a big surge, isn't the simplest way to minimize the loss in such a case to buy stock as soon as such a surge is predicted?

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