The Hindu Business Line : Here’s a way to lock-in minimum gains on your investments

If you took pride in your stock picking skills during the bull run not long ago , the currently volatile markets could have shaken some of that confidence.

After all, it is not an easy task to just sit on the sideline and watch volatility wipe away a good chunk of your hard-earned profits. But worry not, for there is a way to seal minimum profits on your investments – use the protective collar. This simple option strategy can lock-in profits on your stock regardless of the constant meandering in the stock markets and that too at little cost. Interested? Read on.

Using Protective Collar

Simple and easy to set, a protective collar strategy should be used when you are sitting on huge unrealised profits on a stock and want to protect it. It can be established by purchasing a protective put (buying puts at lower strike price) and simultaneously writing a covered call (selling calls at higher strike price) for the same month on the stock that you hold.

For instance, say you hold 175 shares of ICICI Bank bought at Rs 500. This means you would currently be sitting on an unrealized profit of Rs 200 on a per share basis, if we take into consideration the stock’s current market price of Rs 700. You can lock-in on minimum gains using a protective collar.

A protective collar on your ICICI Bank’s shares can be set by selling higher price call options on the stock. Depending on what price you would be comfortable parting with your stock holding, you can decide on the strike price of the call option.

Let us say you sell one lot (175 shares) of ICICI September 740 call option trading at Rs 16.5.

This means that if the stock price moves above Rs 740 during the period of the contract, you should be willing to sell the shares at the strike price. The second part of the strategy involves buying a protective put on ICICI Bank. You can do this by buying puts at a strike price, which would seal the minimum profits you want to lock in for your share holding.

In this case, you can do so by buying ICICI Sep 660 Put option trading at Rs 16.7. This will help you lock-in a minimum gain of Rs 160 per share (Rs 660-Rs 500).

But at what cost? In this example, while selling the 740 call will entail an initial credit of Rs 16.5 a share, the buying of puts will mean a debit of Rs 16.7 a share. So, on a net basis, you have set a protective collar for just 10 paise a share.

Note that different spreads can be chosen depending on your stock price outlook and risk tolerance. Further, in some cases the strategy can also be set at net initial credit.

Possible outcomes

If ICICI Bank’s stock price falls much below the strike price of the put option (Rs 660), gains from the long put position will offset the notional loss in the stock’s value. However, the sold calls will expire worthless. This means you will get to pocket the premium that you received while writing the call (Rs 16.5). Alternately, if the stock price rises beyond the strike price of the call options (Rs 740), it will result in a loss.

However, this loss to an extent will be offset by the rise in value of your gains on ICICI Bank’s shareholding. While the put option will expire worthless, you will stand the risk of exercise at Rs 740, in which case you may have to part with your stocks.

And if the stock price trades in a range between the put strike price of Rs 660 and the call strike price of Rs 740, both the options would expire worthless.

In this case, you lose nothing but the amount spent in setting the spread. But had you set the spread for strike prices that would have resulted in a net initial credit, you would get to pocket that for good.

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