If you’ve been following the stock market closely, you’ve probably read or listened to news stories where pundits and reporters describe the market as “frothy,” “toppy,” and “overheated.” Translation: we could be in for a big correction.
Note use of the words “could be.” The fact is, the stock market could continue on a tear. Or it could keep going up, up, up. No-one really knows.
It’s not the upside you’re worried about right now – it’s the downside. You’re probably not worried about what you might make in the future: you’re looking back at the huge gains we’ve made in the market, and that’s getting you worried about what you might lose.
You need protection. You need insurance against loss. But just like insurance against the loss of your car or your house or your life, insurance isn’t free, and it can be very expensive.
In the stock trading world, insurance against loss is called a “put.” In a put, you pay another investor a certain amount of money per share to sell your shares to her at a certain price.
Say you own 100 shares in Cadbottom Inc. Right now, the shares have risen to $2,005 a share, but you’re worried they’re going to fall. You purchase a put from your friend Helen, so that if the shares fall below $2,000 a share — called the strike price — she will buy them all from you for $2,000 each.
This put costs you $10 per share, or a total of $1,000. But there is a way to get your insurance for free.
You do this by selling a “call.” A call is the right to buy shares at a certain price. You have another friend, Joan, who is prepared to pay you $10 per share for the right to buy your stock in Cadbottom if it rises above $2,010 per share.
Place a put and a call together, and you’ve got a collar.
Well done! You have now protected your investment from losing more than $2000 a share, and you did it for free! The only downside is that if the market in Cadbottom does really well, and the shares rise above $2010 each, you won’t benefit, because you’ll have to sell them to Joan. Doubtless, she’ll be jeering at you, but you’ll have a sack full of cash, and she’ll be the one worrying about insurance.