How to protect your portfolio for free

David Madison | Photographer's Choice | Getty Images

With the S&P very close to its all-time high, many investors who have ridden the market up are looking to get a bit of protection, and rightfully so.

Many are turning to options, and option users have a bunch of, well, options to choose from when they're looking for a protective strategy. A common one is the covered call, which simply means selling a call against a long position. Although it doesn't provide much protection, it does generate premium that we get to keep no matter what, and that premium can soften the blow if our stock sells off slightly.

(Read more: Top technician: Yes, 2013 does look like 1987)

Another common alternative is to purchase puts, which provide a ton of protection, all the way down to zero. The problem is that while a covered call generates income, a put costs money—sometimes a lot of money.

What if we combine those two trades, the covered call and the long put? We would then have a collar. Since a collar is short a call, it's only appropriate against long stock, but when we are long shares at the top, that is when we should be using a collar. And the S&P is very close to its all-time high as we enter a stretch on the calendar—September and October—that has often presented problems for the broad market.

For someone long the S&P 500 ETF (SPY), establishing a protective collar right now might make sense.

(Read more: Three reasons the market is peaking: Doug Kass)

One collar that we could use in the SPY is the November 158/175 collar. We execute it by selling the November 175-strike covered call at $1.70 and using that premium to buy the November 158-strike put at $1.70. The net cost is zero.

What happens at November expiration? If SPY is above $175, then we're going to get our shares called away, and we'll receive $175.00 for them. If SPY is below $158 at November expiration, then we're going to exercise our put option, and we'll sell our shares for $158.00, regardless of how much lower they're trading at the time.

(Read more: Rocky September ahead, warns BlackRock strategist)

Since the whole trade costs us nothing, it's fairly called a zero-cost collar, but that doesn't mean the trade is free. Notice that SPY closed Tuesday at $169.61, which means that if SPY rallies just 3.2 percent, we'll have our shares called away. But protection doesn't kick in until that 158-strike, which 6.8 percent away.

This difference between 6.8 percent and 3.2 percent shows this collar's real cost to the investor. Those downside puts tend to be more expensive than upside calls, because buyers of protection drive up the cost of the puts, and covered call sellers drive down the price of the calls.

That doesn't mean you should never use collars. It just means the math is working against you a little bit, and you have to use them tactically. SPY will pay a dividend on Sept. 20, and a collar will allow you to collect that dividend. You have the opportunity to enjoy a little more upside and yet have protection if something ugly happens.

—By Scott Nations, President and Chief Investment Officer of NationsShares

Follow the show on Twitter @CNBCOptions.

Latest Video


Host Bio

  • Melissa Lee

    Melissa Lee is the host of CNBC's “Fast Money” and “Options Action.”

Options Action Traders

From Our Sponsor

Sign Up for Our Newsletter Options Action

Insight directly from the members of our Options Action panel
Get this delivered to your inbox, and more info about about our products and services.
By signing up for newsletters, you are agreeing to our Terms of Use and Privacy Policy.