Using The Collar Trade
By Jim Graham - Product Manager, OptionVue Systems International.

In current market conditions, option traders really appreciate the advantage that they have over pure stock traders.  The President of OptionVue Systems, Len Yates, has written many articles explaining how to sell options and take advantage of a market where implied volatilities are at an all-time high.  Covered writing, selling naked puts, spreads, and the covered combo are all strategies that work well in bear and sideways markets.  And market conditions like we have experienced recently are a great time to examine your open positions, looking for changes or adjustments that can be made to create a better risk profile.

I'm primarily long-term bullish on the market, but as we have seen this past year, having only long positions that ignore downside market potential can be disastrous. That's why it is important for option traders to also use delta neutral strategies or create hedged positions. Many of our customers have the bulk of their assets in stock holdings, and use the leverage inherent in options to take advantage of shorter-term opportunities without having to actually purchase the stock. However, there is a lot you can do to protect your portfolio using options, such as buying a put or using a collar trade.

Buying a protective put is the simplest way to protect gains in a stock. Similar to an insurance policy, it protects you against losses for a fee (the premium paid). The put is a contract that gives you the right to sell a security at a given price - the strike price - on or before a specified date. Suppose you have a share of stock valued at $50, and buy a put option with a strike price of $45. If the stock price drops, you bear the first $5 of losses yourself. No matter how far the stock price drops below $45, you won’t lose any more than that $5. What happens at the option’s expiration? If the stock ends up at more than $45 a share, the option is worthless. But if the stock price ends up below $45, your gain on the put equals the loss in the stock. The advantage to this strategy is that you keep all the gains (minus the put premium paid) no matter how high the stock price goes; yet you're perfectly insured below $45. The downside to this strategy is the cost. Especially in bull markets, traders end up grumbling over their lost put premiums. Over a long bull market, most investors will simply stop buying the puts.

One way to get around paying for downside protection is to use a collar trade. A collar trade is a hedge that confines your risk to a particular range. To construct a collar trade, you buy put options to protect yourself from downturns and simultaneously sell call options to help pay for the puts.  It is even possible on many stocks to create what is called a "costless" collar, where the money collected by selling the calls completely pays for the puts. What the collar does is lock you into a protected price band. You are protected if the stock falls below the strike price of the put, but you forfeit any profits above the call's strike price.  This trade can be easily constructed and analyzed in the Matrix to fit your particular situation.

Let’s use Microsoft (MSFT) as an example of a stock you might want to buy. It is currently trading at $56.69. Looking at the April options in the Matrix, you could sell the April 65 call for $1.30 and the buy the April 45 put for $1.25. The risk graph of this collar trade looks like this:

1. The stock price could remain between $45 and $65. In this case, both options will expire worthless and you own 100 shares of Microsoft. Since the options cost you virtually nothing, you are no better or worse off than if you had simply bought the stock.
2. The stock price could drop below $45 on the expiry date. In this case, you will lose $1,196 no matter how far the price drops. This is the "floor" established by the collar. For comparison, if the price drops to $40, you would lose $1,619 if you only bought the stock, and your losses would continue to mount if the stock price declines further.
3. Microsoft stock could surge past $65. If this happens, your shares will be assigned at $65 no matter how high the stock price climbs. You will make a profit of $831 for these 57 days, a 15% yield (94% annualized return).

The collar strategy can also be very helpful if you have unrealized gains to protect. I'll use the example of Electronic Arts (ERTS), a video game company. It is a well-managed company with a dominant share in PC games, and has more game titles available for the Sony Playstation 2 and the upcoming Microsoft X-Box than any other competitor. Looking for strong growth in the video game market this year, I purchased some stock at $37.50. Within the past month it has risen to $53.06.

Using the April options again, I saw you could buy the 50 put for $4.50 and sell the 60 call for $3.80. Note this is not a "costless" collar like the previous example. The cost of putting on this collar will be net difference of $70 plus commissions. Structuring the trade this way allows you to lock in more of the gain (you could buy the 45 put for only $2.50) while keeping $7.00 of upside potential on the stock price. See the diagram below:

There are many ways to structure a collar trade. You can purchase an at-the-money LEAPS put and sell an out-of-the-money LEAPS call. This trade can also be structured as a no risk position at expiration by using a call and put at the same strike, if that's the desired risk profile the trader is seeking. What happens when the underlying stock goes into free-fall while you're sitting in this position? Depending on how far away the option's expiration is, the overall position will probably have a small loss if the put is bought at a lower strike price than the stock is trading at, but that loss is always less than if the underlying alone was purchased.

Are there adjustments that can be made to increase the overall profitability of the position if the stock price were to fall dramatically? Of course! The adjustment is to sell the long put and buy back the short call, and put a new collar on the stock. If the price of the underlying stock has decreased, a profit will be realized on the sale of the long put, and another profit realized on the purchase of the short call. The new collar will continue to protect the position to the downside and allow for profits to accrue when the stock heads higher. This adjustment should not require much, if any, additional cash from your account. The sale of the put should provide the cash needed to buy back the short call. The new collar can be structured so that selling the call finances the cost of the put. It makes sense to look at doing an adjustment if the stock has dropped by around 20% or so. What a powerful strategy! You lock in profits on a long-term bullish position with no risk while the stock price itself is collapsing.

What if the underlying stock were to take off while you are in a collar? Just lock in the profits you have already built up. There are a number of ways to do this. One way would be to sell the put and buy back the call, and then put the collar on again using an at-the-money put and an out-of-the-money call similar to the ERTS example above. Another possibility would be to purchase some in-the-money puts against the long collar. A put ratio backspread could also work well in some situations. There are all types of ways to trade around your core positions. Once you've played around in the matrix with possible collar plays, try designing your own strategies. For example, a "bear put spread" in conjunction with the underlying insures you against losses if the price goes down a modest amount, but leaves you completely exposed to losses if the stock collapses.

What's a trader to do? Just try to relax and take advantage of opportunities as the market provides them. Instead of being upset at the difficult trading environment, use your options knowledge to capitalize on the opportunities available. The benefit of the collar trade is that it works well in all kind of markets. It is a low-cost way to provide downside protection, allows you to protect existing gains, and is easy to adjust as the market changes.

* Option strategies carry inherent risk of large potential losses. As such, these strategies may not be suited to every investor.