No Free Lunch

The Till - Vol #20 - January 9th, 2020

One of the truisms of investing, is that there’s no such thing as a free lunch. If you’re getting something for free, it either means you are the product, or you are being sold something else.

Options markets however, can offer something that’s very valuable, for zero cost. By exchanging upside gains for downside losses, a zero cost collar locks in the value of your equity for free.

Emotionally, it’s much easier to buy a stock than it is to sell a stock. The considerations for investors that are sitting on capital gains can be vexing. Do I think this will go higher? What happens if it goes lower? Is now the right time to sell?

This decision making can be even harder when you’re the beneficiary of inherited stock or have received stock as a form of compensation. For employees of public companies, equity can be a significant portion of their earnings. While it has the benefit of aligning all the stakeholders, it also creates concentration risk.

When you worked hard for your bonus or are now holding someone else’s investment, do you really want it subject to both specific and market risk?

The history books have as many stories of tech employees getting rich off RSUs as they do of employees in Enron or WorldCom losing their life savings. When your paycheck and net worth are tied up in the same place, it can be a lot of eggs in one basket.

A zero cost collar is one of the simplest options strategies, but it serves an incredibly powerful use case. As the name implies, a zero cost collar puts a “collar” around the stock movement's effect on your returns. You’re protected if the stock goes down, and your exposure is flat on the upside.

The idea here is that you’re giving away potential growth in the stock (similar to selling a covered call) and using that premium to buy downside protection. The amount of downside exposure you’re willing to sustain, determines how much upside you’ll maintain.

A good rule of thumb is that you’ll bear as many percentage points of downside losses as you want to keep on the upside. You could have a very tight collar with less than a 1% change in value, or accepting some fluctuations, take 10% downside risk vs. 10% upside potential.

The beauty of this position is that it preserves capital value for no cash payments. You’re simply taking advantage of the prices of options to lock in your current equity value.

Entering into a zero cost collar lets you hit the pause button on your holdings. It will lock in your value exactly where it’s at today. It’s a strategy that costs you nothing, but provides something.

Thanks for joining us,

Mark Phillips
CEO