By: Larry MacDonald

With stock markets down sharply today,  what better time to  feature the views of investment author and blogger Mark D. Wolfinger. He believes “options are the best risk-reducing investment tools on the planet.”

“The traditional techniques for managing portfolio risk are asset allocation and diversification,” he says. “Those ideas aren’t ‘wrong’ but they’re not good enough for today’s markets …. stock options provide the safety net that most folks need.”

Consider the following guest post from Mark, on the collar technique:

Option collars represent a basic, easy to understand and implement strategy that guarantees the safety of your stock market portfolio. Guarantee is a strong word, but it’s the truth.

Here’s how it works: You own 100 shares of stock, or, for passive investors, an ETF that mimics the performance of a broad-based market index. It may be SPY (S&P 500), IWM (Russell 2000) etc. The only requirement is that the ETF has listed options.

Next, buy one put option, giving you the right to sell those 100 shares at a predetermined (strike) price. Then sell one call option, granting someone else the right to buy your 100 shares at a predetermined (strike) price.

Often you collect enough cash when selling the call to pay for the put. That gives you the collar at no cash cost. The put strike price sets the maximum loss and the call strike price sets the maximum profit.

Such safety does not come free, so what’s the cost? There are two costs. First, as with any insurance, choose the deductible and decide how much you are willing to lose if the market tumbles. A reasonable choice is 5%, but it’s up to the individual investor. The second cost is the necessity to limit upside gains. You profit on rallies because collars are slightly bullish, but gains are strictly limited. No more +30% annual gains for collar owners.

Options have limited lifetimes, so this trade must be repeated at a time interval that suits you: one month, one year, or longer.

This is a very brief discussion, but what you get is guaranteed protection coupled with limited gains. Is that for you?

For an example, see this post by Mark. He also has written several books on options, such as the Rookie’s Guide to Options, wherein can be found more discussion of collars.