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Options Trading: How to Use a Collar to Choke Off Risk


Collars are a great solution to help steady your portfolio during uncertain times, or to simply lock in a range in which you'd be happy to sell a particular position.


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With the saber rattling around Iran, potential slowing growth out of China and Brazil, earnings warnings out of Ciena (CIEN) and Cypress Semiconductor (CY) this morning, and yesterday's reminder that markets don't go straight up, many investors find themselves in a pickle: They are sitting on nice gains as the S&P 500 has rallied some 25% since the October lows. Many stocks are seeing even greater gains and are at all-time highs. It's tempting for investors to take some profits here, but at the same time, they don't want to indiscriminately dump their holdings now and potentially miss further gains.

If an investor sells a holding now, it may be psychologically difficult to reestablish the position at higher prices. Also, wholesale liquidation could have tax consequences. And for dividend-paying stocks, that could mean losing some important income in this yield-starved world.

A lot of investors would like a way to put their positions on hold while they wait for the market to digest recent gains and try to get more clarity on the geopolitical situation and the eurozone crisis. One way an investor can do this is by using options to establish a collar.

A collar is a position consisting of long stock, long put, and short call. The sale of the call helps finance the cost of the put. When the put and call both have the same strike price it is called a conversion. This strategy can be done in conjunction with a new stock purchase, but it is typically used to lock in a minimum sale price on an existing long-stock holding.

Because a conversion essentially locks in the stock's current price -- meaning there's neither upside profit potential nor downside risk -- the IRS might consider it a constructive sale. Conversions, therefore, have tax implications. To consider these, we'll focus on creating a collar using different strike prices, which creates a wider but limited band for losses or further gains.

How Long a Leash?

For example, assume you own 1,000 shares of IBM (IBM), which has chugged to all-time highs as it has gained over 28% in the past 52 weeks. You're worried that if the economic recovery stalls and business spending slows you might want to establish a minimum sale price as you wait to see how things play out.

With IBM trading around $198 a share, you could establish a collar by purchasing the July $190 put for $6.80 per contract and selling the July $210 call for $4.10 per contract. This is a $2.70 net debit, giving the stock an effective cost basis of $200.70 per share (the current stock price, plus the net debit of the collar).

This locks you into minimum sale price $190, if you exercise the put option, and would result in a $10.7, or a 5.3% loss, from your current effective cost basis.

The maximum sale price is $200 if the call is assigned, providing a $9.30, or 4.9% gain from the current price. In this example, the reduced profit potential is offset by two quarterly dividend payments of $1.50, which will be made before the July options expire.

Your market view and timing considerations will help determine which strikes and expirations to use. For instance, if you just need to ride out a few turbulent weeks or an upcoming event -- such as an earnings report, or a court or regulatory ruling -- then using short-dated options makes sense.

If, on the other hand, you're still fundamentally bullish on your holding, you might want to use longer-dated options with wider strike prices that will allow for more potential upside. But be aware: This will also expose you to more risk.

Collars are a great solution to help steady your portfolio during uncertain times, or to simply lock in a range in which you'd be happy to sell the shares. But note that this comfort also comes with some opportunity cost. The money (margin or otherwise) needed to maintain the collar position is essentially dead money, whereas the proceeds of a sale of the long stock could be reinvested -- even if it's at the current paltry money-market rates.

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No positions in stocks mentioned.

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