Fiscal cliffs, debt ceiling debates, euro zone worries, and a slowing economy have investors wondering what they should do now… Buy and hold? Trade the fast burners? Buy gold coins and bullion? Go to cash? Just what exactly should an investor do in such uncertain times?
When the day to day price action in the equity markets are driven more by sentiment than fundamentals investing becomes a challenging endeavor. It’s not that these sentimentally driven trends are unjustified: they are. It’s more a matter of decreased interest in forward speculation as the uncertainties facing the broader economies of the world are very real. So given that the future economic health of all economies around the world are in question, what’s an investor to do?
In uncertain markets, risk management, the protection of one’s assets, takes on a dominant role. Going to cash for buying hard gold, while protecting the portfolio to the downside, in general do not allow for any upside growth. Alternative strategies can and should be implemented in uncertain times. For those who trade options either individually, or combined with equity positions, there are strategies that make good sense.
For those who hold equities in the portfolio, and wish to continue to hold these equities, the collar trade becomes the appropriate strategy. The collar trade is made up of three financial instruments:
- The long equity itself
- A long put
- A short call
The collar trade is an extremely flexible strategy. Because of the flexibility of its construction, it can optimize a bullish trend, a stagnant trend, and even a slightly bearish trend. It is a trade that is dynamic and allows for almost infinite modification based upon the invest ores expectation. More specifically the two option instruments provide for the following:
- The long put provides the owner the right to sell their equity at the strike price of the option chosen for the length of time of the long put contract. Typically, an investor or would purchase a long put where the strike price is very near the current value of the underlying equity. Further, the invest or would purchase this long put with a minimum of 45 days until that auction reaches its expiration. Beyond these basic application principles, the variations are almost infinite.
- The short call obligates the seller to provide the underlying equity if the short call option is assigned. The equity will be transferred at the strike price of the option sold. The credit generated to one’s account by the sale of this short option helps to reduce the amount of risk a portfolio is exposed to. It’s application can be any amount of time value desired. The strike price chosen can be out of the money, at the money, or in some applications, even in the money. As with the long put, the variations in structure are limitless and the actual structure chosen must be based on the investor’s expectation.
Credit trades are another very popular approach to trading uncertain markets. The two most popular credit trades are the bull put in the bear call. Both of these trades optimize several trends, though by their namesake it should be clear which trends would be the most appropriate for each of these two trades. Both of them involve selling an option as the primary instrument and then purchasing a long option some strike price is a way from the strike price of the short option. This is done to limit potential risk should the equity trend against this particular trade. In either one of these trades, a viable secondary exits (i.e. what you would do if the trade goes against you), would be to purchase the underlying equity either through obligation (as with a short put), or by outright purchase in the case of the bear call. As long as an investor or is willing to purchase the underlying equity and then make appropriate adjustments, either one of these strategies make sense.
Uncertain times require the investor to take calculated risks and appropriate protective steps in order to limit potential damages to the portfolio. Even in times such as these, there is money to be made in the markets, the educated investor knows this and knows his tools.