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.
Follow Steve Smith's options trade with OptionSmith
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.
For more from Steve Smith, take a FREE 14-day trial to OptionSmith and get his specific options trades emailed to you along with exclusive access to his full portfolio. Learn more.
Follow the markets all day every day with a FREE 14 day trial to Buzz & Banter. Over 30 professional traders share their ideas in real-time. Learn more.
The information on this website solely reflects the analysis of or opinion about the performance of securities and financial markets by the writers whose articles appear on the site. The views expressed by the writers are not necessarily the views of Minyanville Media, Inc. or members of its management. Nothing contained on the website is intended to constitute a recommendation or advice addressed to an individual investor or category of investors to purchase, sell or hold any security, or to take any action with respect to the prospective movement of the securities markets or to solicit the purchase or sale of any security. Any investment decisions must be made by the reader either individually or in consultation with his or her investment professional. Minyanville writers and staff may trade or hold positions in securities that are discussed in articles appearing on the website. Writers of articles are required to disclose whether they have a position in any stock or fund discussed in an article, but are not permitted to disclose the size or direction of the position. Nothing on this website is intended to solicit business of any kind for a writer's business or fund. Minyanville management and staff as well as contributing writers will not respond to emails or other communications requesting investment advice.
Copyright 2011 Minyanville Media, Inc. All Rights Reserved.
Daily Recap Newsletter