Perhaps the most conservative options trading strategy is the collar trade.Perhaps the most conservative options trading strategy is the collar trade.
The collar trade strategy combines stocks and options to limit risk. So if risk is reduced, what’s the catch?
Well, just as you lower the risk, so too do you limit your upside.
It’s a double-edge sword because you can’t lose a whole lot but equally you may not be able to make a big return.
But when you are trading the most volatile stocks, limiting risk may be your priority, even if your upside is capped.
How the Collar Trade Works
A collar trade limits the effects of stock volatility on your portfolio balance.
No matter how high or low a stock goes, the collar trade will have a fixed reward and risk.
The way it works is for every 100 shares of stock you own, you would purchase 1 put option and sell 1 call option.
The put options act as an insurance policy that limit your risk. Even if the stock plummeted, the amount you could lose would be limited to a specific, fixed amount.
But unlike a regular insurance policy where the full cost to buy it comes out of your pocket, the cost of the insurance is somewhat offset in a collar trade by the sale of the call option.
Investing Tip: Collar Trades can significantly reduce account balance swings compared holding volatile stocks alone.
Collar Trade Example: Let’s say the volatile stock you own is priced at $100 per share.
And we’ll imagine that you pay $5 per share (or $500 per contract) for the put option and receive $2 per share ($200 per contract) for the call option.
So the trade might look something like this:
| Stock Price | $100 |
| Put Option @Strike Price 100 | $5 |
| Call Option @Strike Price 110 | $2 |
So the risk in the trade is $3 per share or $300 per contract.
The maximum you can make is limited by the call option strike price.
Your upside is capped because when you sell a call option you are obligated to sell your stock if the price rises above the call strike price of $110.
The maximum profit potential is $7 per share, which is the difference between the call strike price of $110 and your net cost basis, which is $100 per share for the stock plus $3 per share for the put option or $103 in total.
If you don’t like the idea of limiting your upside, you can ditch the call option.
This results in a new trading strategy, called The Married Put.
How to Apply
The protective put option is still applied but the call is not sold.
So when would you want to choose the married put vs collar trade strategy?
When you believe the share price has the potential to move significantly higher, the married put may be the better choice.
Even though you take on more risk with the married put strategy (because no call is sold to somewhat offset the put purchase price), the reward to risk ratio may make it worthwhile.
The collar trade is usually the better choice when the share price is in a downtrend and expected to continue trending lower.
Investing Tip: Married Puts limit downside risk while upside potential is theoretically unlimited.
Example A married put trade may look something like this:
| Stock Price | $100 |
| Put Option @Strike Price 100 | $5 |
The overall cost basis of the combined stock and options trade is $105.
And the risk in the trade is the difference between the cost basis and the put strike price, so $5 per share in this case.
But unlike the collar trade, which has limited upside reward potential, the upside in the married put is theoretically unlimited.
The higher the share price rises, the more money you make.
However, as the share price rises the put option will generally lose value.
So you will need the share price to rise above $105 to breakeven in the trade by the time the put option expires.
No matter which strategy, married put or collar trade, you may choose, make sure to select one of the best options trading brokers to avoid any hiccups with trade executions.
How To Get Paid Trading The Most Volatile Stocks
Another way to trade the most volatile stocks is the covered call strategy.Like the collar trade strategy, the covered call involves selling calls against shares already owned. But unlike the collar trade and the married put strategies, no put options are purchased.That means the downside risk is significantly higher when trading covered calls vs married puts or collar trades.
However, the covered call is a good income-generating strategy when the stock is not trending lower.
Related: High Dividend Stocks: A Lonely Opportunity
Investing Tip: Covered Calls limit upside potential but can produce regular income opportunities.Covered Call Example
Sticking with the same share price of $100, a covered call may be structured as follows:
| Stock Price | $100 |
| Call Option @Strike Price 110 | $3 |
Unlike the married put and collar trade strategies, the covered call nets you money.
While you have to take money out of your pocket in the other options trading strategies, the covered call is an income-generating strategy with a cost basis under the share price.
In this case, the cost basis is just $97, the share price ($100) minus the $3 per share earned when selling the call.
What makes the covered call so attractive is not only the income from the sale of the initial call but also the ongoing income from continually selling additional call options in further months.On the most volatile stocks, call premiums tend to be higher than those on slow-and-steady stocks.
Why Trade Options On The Most Volatile Stock
Options offer traders a number of valuable features when trading the most volatile stocks.
For many traders, volatility quickly leads to fear. It’s a rocky ride watching an account balance undulate in the blink of an eye.
Without options to protect downside risk, you may need to become proficient at technical analysis to manage risk.
However, options don’t just afford you protection but income too. And the yield can be significantly more attractive than the rates paid by savings accounts.
Earning just $3 per quarter from selling call options on a $100 stock would amount to a 12% return annually all else being equal.That’s nothing to sneeze at and makes it well worth your time learning how to trade options.
How To Find The Most Volatile Stocks Today?
So now you know what strategies can work to your advantage on volatile stocks but how do you find the most volatile stocks today to trade?Technology stocks like Facebook, Alphabet, and Netflix have all historically had volatile periods and, at one time or another, attractive call premiums. But over time even the most volatile stocks tend to stabilize. So how do you find a list of the most volatile stocks?
First define the types of stocks you wish to trade, for example:
- Most volatile stocks to day trade
- Most volatile stocks weekly.
- Most volatile stocks this month.
- Most volatile stocks under $100
Once you have defined criteria, screen for a list of the most volatile stocks using TradingView, FinViz, or some other stock screening tool.Then double check to make sure the stocks on your list are optionable if you plan to apply married put, covered call, or collar trade strategies.
It’s hard to track a lot of companies simultaneously, so you may wish to narrow your list down to the top 10 most volatile stocks that meet your criteria and create a watchlist.
Then the best next step is to virtual trade strategies that suit your investing style. Brokers like thinkorswim and tastyworks provide virtual trading platforms so you can test out stock, option, and futures strategies risk free and learn what works best for you.
This article has been republished with permission from Investor Mint.