Beginning Option Strategies/Hedging

Protecting a Position with Collars

Andrea Kramer (akramer@sir-inc.com)

Has this ever happened to you? You bought a stock, and it has performed well, but now you’re concerned that a pullback threatens your hard-won gains. This article examines a way protect profits on a stock you already own utilizing collars.

Who should tune in? Collars are often utilized by traders who have seen a recent rally in a stock they already own, and want to protect their unrealized profits from a pullback. (Some investors also use collars to make a profit by selling them for a credit. However, if making money is your ultimate goal, make sure you can devote plenty of time and attention to manage the trade.)

How does it work? A collar is implemented by purchasing a protective put on a long stock position. The trader then helps to offset the cost of the put by selling a covered call on the same stock with the same expiration date. Typically, both options will be out of the money.

The put strike should be high enough to lock in most of the investor�s unrealized profit, while the sold call strike should be high enough to enjoy some upward price momentum, but not so high that the premium isn�t enough to partially counteract the cost of the put.

What�s in it for me? While the written call helps to offset the protective put position, the call strike also limits the collar�s upside potential. The investor�s objective is for the underlying shares to be above the sold call strike at expiration so the stock is called away. If assigned, the trader can sell the shares at the strike price, locking in a profit over what he initially paid for the stock.

If the sold call is less expensive than the purchased put, the trade will be established for a net debit. In this case, the breakeven level on the collar is calculated by adding the net debit paid to the stock price at initiation.

On the flip side, if the protective put is the least expensive of the two legs, the trade will be established for a net credit. In this case, the breakeven level on the position is calculated by subtracting the net credit received from the stock price at initiation.

At the time of initiation, the maximum profit potential of the collar is limited to the sold call strike minus the current stock price plus/minus the net credit/debit on the trade.

What do I have to lose? While the sold call strike caps the collar�s upside, the purchased put strike depends on the investor�s downside risk. The further out-of-the-money the put strike is, the more the trader has to lose on this play.

At the time of initiation, the maximum potential loss of the collar is limited to the current stock price minus the put strike plus/minus the net credit/debit on the trade.

In addition, don�t forget to include any brokerage fees or margin requirements when calculating the total cost of this play.

Let�s look at an example.

Meet Holden, a rookie option trader who bought 100 shares of ABC for $30 apiece a few years ago. Since then, the stock price has doubled to $60, and Holden wants to protect unrealized profits, even if it means sacrificing future gains in return. With that in mind, he decides to step into the world of options by initiating a collar on ABC.

If Holden buys an August 55 put, he�ll have the right to sell his 100 shares of ABC for $55 each, or $5,500 total. Compared to the $30 per share, or $3,000 total, he paid for the stock originally, Holden is guaranteeing a profit of $25 per share, or $2,500 total, by purchasing the put.

In the other leg of the trade, Holden opts to sell an ABC August 65 call. That way, if the shares of ABC rally past the $65 level by August expiration, the option will have a great chance of being exercised. Holden would then receive $6,500 for his 100 shares, making a profit of $3,500 compared to his original purchase price. However, he would no longer own the shares, meaning he could miss out on a rally past the strike price.

In this example, let�s assume the put cost $2, or $200 (x 100 shares) to buy, while the call sold for $1, or $100. Since the put cost more than the premium received for the call, Holden�s collar was initiated for a net debit of $1, or $100 ($200 — $100). However, the $100 paid is only half of what the cost of a lone protective put would�ve cost.

Since the trade was established for a net debit, the breakeven level on the option play would be $61 (current stock price of $60 + net debit of $1). In other words, to avoid a loss on the position, Holden needs the shares of ABC to remain at or above the $61 level by options expiration on Friday, August 21.

Now, let�s assume the shares remain at the $60 level at expiration, meaning both options could expire worthless. In this case, Holden would forfeit the $100 paid for the collar, and retain his 100 shares of ABC. The good news is, this is the most he can lose on the trade.

If the shares of ABC fall beneath the 55 strike at expiration, Holden could then exercise his put, selling his stock for $55 each, or $5,500 total. No matter how far the security falls before expiration, by initiating the collar, Holden has guaranteed himself a minimum selling price to unload his shares � and all for a net debit of $100.

Words of wisdom

In conclusion, the primary benefit of a collar is that it�s a relatively cheap way to insure against steep declines in a stock you already own. This strategy is less expensive than purchasing a lone put, as the profit from the sold call offsets the cost of the put. In addition, the flexibility with strikes allows the investor to better control the risk-reward scenario.

On the other hand, like many other conservative strategies, while your downside risk is limited, so is your upside potential. Furthermore, keep in mind that by initiating a two-legged strategy, you could incur double the brokerage fees.