Wednesday, 8th September 2010

Protective Collars

Written by George Traganidas Topics: Articles, Options, Wealth Building

Fool.com
By Jeff Fischer
August 10, 2009

Protective collars are useful in bear markets or when you’re uncertain about a stock’s valuation risk. They can also be a prudent way to protect your gains on stocks that have recently leaped in price, nearing your estimate of fair value. Let’s explain how collars work, starting from the beginning.

Insure Your Positions by Buying Puts

As a long-term investor who remains committed to your core holdings, you may be reluctant to sell even if you see storm clouds on the economy’s horizon. After all, life is full of ups and downs, and you can’t simply disengage when the going gets tough. However, when it comes to equities, you can protect your portfolio by purchasing put options.

That’s right. Purchasing options — not selling them. When we buy options, we’re not under any obligation regarding shares of the underlying investment.

So if we buy puts on a stock we own, and the puts gain value for us, we’ll simply sell those puts later for a profit and still keep our shares of the underlying stock (assuming we want to). In other words, when we buy them, we’re using options as a strategy on their own, without needing to get the underlying stock involved unless we want to.

Now let’s explain buying puts, specifically. A put option goes up in value when the underlying equity or exchange-traded fund declines in price. So when you buy a put, you’re basically buying insurance for your investment. A put gives its owner the right to sell the underlying investment at a minimum set price (the strike price) by a set date (the option’s expiration date) no matter how far it falls. In times of uncertainty, buying puts to protect your key holdings makes plenty of sense. However, it can be expensive — and who wants to shell out piles of cash for insurance policies that will one day expire?

Enter the costless collar. Using this strategy, you buy your puts — your insurance — with funds you receive from the concurrent sale of call options, thus saving yourself the cost of the puts.

The Costless Collar: Buy Puts, Sell Calls

Assume you own shares of Stock XYZ. You believe the underlying business will reward investors in the long run, but in the intermediate term, you still see risk to the downside. You want to protect your investment against a large decline, just in case.

For our example, assume the stock is trading at $21. For a costless collar, you want to buy puts and sell (“write”) calls to pay for them. Let’s say (using real-life quotes available as I write this) that the $19 strike price put options expiring in seven months can be purchased for $2.30 per contract. Also, the $24 strike price call options can be sold for $2.10 per contract. The puts will protect you from a meaningful decline in the stock’s price, and selling the calls to pay for them means your net cost for the strategy is only $0.20 per share plus commissions (remember, you’re paid $2.10 for selling the calls, and you need to pay out $2.30 to buy the puts). Nice — that’s cheap insurance.

The real cost of implementing a protective collar is limited upside. If shares of Stock XYZ exceed $24 by your call option’s expiration, you’ll miss any upside above that price and need to sell your shares at $24. But if the stock price declines over the next few months, you’ll be glad you set up the collar. The puts will provide a profit, and the calls you sold will expire. Meanwhile, you can keep holding your shares to await eventual gains.
Insure Your Positions and Keep Upside, Too

There is a way to insure your investment and maintain unlimited upside potential on at least some of your shares. Assume you own 600 shares of Stock ABC, bought at $21. Looking at the options that expire in 10 months, you can sell $25 strike price covered calls for $4 per contract. With the proceeds, you can buy the $17.50 strike price puts for only $2 per contract. This means you can protect all 600 shares by buying six puts, but you only need to sell three calls to pay for it — and you still pay nothing out of pocket.

Your full position is protected against a sharp decline, and half of your shares still have unlimited upside potential since you didn’t sell calls on them. This type of strategy combines the best of both worlds: Limited downside and unlimited upside.

Bottom Line

Collars can smooth returns, help hedge your portfolio, protect a holding, and allow you to ride out a rough market with more confidence. They’re not for everyday use, but they’re useful in situations that merit protection.

Collar Cheat Sheet

  • Protective collars can be used to shield against downside risk in rocky markets or to safeguard gains when you’re not ready to sell — but would willingly sell at slightly higher prices.
  • Buy puts and sell calls with the same expiration date but different strike prices (the most attractive available).
  • You can “cover” all or some of your shares.
  • The position you’re protecting usually needs to decline soon — or sharply — for puts to pay off handsomely.
  • Don’t sell calls on stocks you’re not willing to sell or that you believe are grossly underpriced.
  • Typically seek to use options that expire in six months or more — or even Long-Term Equity Anticipation Securities (a.k.a. LEAPS) that expire in 18 months or more. This allows you to choose more advantageous strike prices and be paid more for the calls.
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