CHAPTER lll - LONG STOCK PART 5 - Collars

COLLARS It was discussed that we add a protective put to our long stock position as a means of hedging our position, so entirely reducing our risk while still allowing us to take advantage of any upward rise in the stock price. We also spoke about selling covered calls, an approach that generates extra revenue while also increasing our return on investment (ROI) but putting a ceiling on our potential earnings. If we were to combine the two positions, we would likely arrive at a strategy that entirely protects us from losses on the downside while allowing us a little profit on the upside. A collar serves this purpose well.

A collar combines a covered call with a protective put. Typically, both the call and put are one strike OTM. In many instances, the premium obtained from selling the call is sufficient to cover the cost of purchasing the put, resulting in a debit/credit collar with no or no cost. Due to the fact that the covered call is out of the money, you may still participate in the stock's upward movement up to the strike price. As for downside protection, the protective put's out-of-the-money status only offers a hedge if the stock falls below the put's strike price. Therefore, there is a limited opportunity for profit on the upside, and there is a limited opportunity for loss on the downside. Collars are considered regarded be "set and forget" strategies since the risk and return are predefined until expiry, therefore the position does not need daily monitoring.

OPENING POSITION – REGULAR COLLAR

Conservative investors might benefit greatly from adding a collar to their first stock purchase. No matter how low the stock goes, the total loss on the position is capped by the put, and no matter how high it goes, an exit plan is set up by the covered call. This is the bare-bones, no-brainer form of risk management, and it's a great illustration of how options simplify risk management in stock trading.

Let's pretend you just bought $100 worth of EBAY stock, and the price of a two-month $105 call option and a two-month $95 put option are selling for $3.00 and $2.75, respectively.

To activate the collar, one must simultaneously sell the $105 call and buy the $95 put, resulting in a net credit of $0.25. If EBAY's price is $105 or higher at the time of expiry, you will make a total of $5.25 ($5.00 profit on the allocated shares + $0.25 credit). If EBAY is trading at $95 or less at expiry, you stand to lose a maximum of $4.75 on the collar ($5.00 loss on stock from executing put minus $0.25 credit). Risk/reward for the EBAY collar is seen in Figure 3.15.

The collar provides a predetermined exit point on the upside of $105 and a predetermined stop loss price of $95 on the downside. Between these two points, you accept the loss or gain from the movement of the

stock. The collar creates perfect risk management parameters and removes some of the thinking from the trade. You can simply let EBAY run over the next 2 months without worrying about at what price to sell

on the upside or when to cut your losses on the downside. The price for this security of course is that you do not participate in any upward movement of the stock above the covered call strike price and you are liable for the loss in the stock below the strike price of the put. This is a small price to pay for the benefit of conservative risk management.

Collars are often installed for free or at a credit. The greatest part about these collars is that the extra security doesn't cost you a dime. If the stock pays dividends throughout the life of the collar and the collar was taken out in exchange for an initial credit, the amount of the credit and dividends received will be subtracted from the maximum risk and added to the maximum profit. Consequently, if you believe dividend-paying equities will rise, one tactic is to buy credit collars on those shares. At the end of the collar's term, if the stock price is within the collar's striking pricing, the holder has the option to either sell the shares and keep any unrealized profit or roll into a new collar at the same or a lower price.

Alternatively, if the 2-month collar placement period seems too short, the longer time options are available as well. Additionally, LEAPS may be used to set up collars. Remember that although a collar limits your risk, it also limits your upside. As a result, if you want to utilize LEAPS to form a collar, you'll need to be ready to give up any gains made above the short strike price and, more significantly, to wait until near expiry before your stock is called away to realize your winnings. Selecting dividend-paying companies may help mitigate the impact of waiting for the stock to be called away. Since assignment is more probable around the expiry of the LEAPS, you may still make a return by collecting dividends while waiting for the stock to be called away if it has gone higher.

Always keep in mind that as long as you are the stockholder, the collar position is protected against the short call. You must remember to close out the short call position at any moment the put is exercised (if you choose to), even if the price of the call has dropped below $0.05. A naked call position is created when a put is exercised but a short call is left, leaving the trader vulnerable to limitless losses if the stock suddenly rises over the short call's strike price. Collars eliminate the need for substantial margin that would be necessary for a short call but are unnecessary for a covered call. Therefore, while exiting the trade, remember that the short call should not be left uncovered if the stock has not been called away.

Out-Of-The-Money (OTM) calls and puts are not required to open a collar. You may establish an upward-biased collar by buying an at-the-money put and selling an out-of-the-money call to hedge against potential losses. Collars are often used for a net debit, although a modest one, since the ATM put will cost more than the OTM put and the premium obtained from selling the OTM call will not cover the cost of the put.

Selling the out-of-the-money $105 call and buying the at-the-money $100 put for a net negative of $1.25 would allow you to set up an upward-bias collar on 100 shares of EBAY if the stock were $100. Because you bought a protective put from ATM, your maximum loss will be restricted to $1.25 even if EBAY falls to $0 before expiry. If you buy EBAY for $100 and sell it for $105 (after subtracting the net debit you'll have to pay), your maximum profit is $3.75.

You can see that the upward-bias collar has a substantially lower maximum risk in exchange for a much lower maximum return by comparing the collars' risk/reward profiles in Figure 3.16. However, the highest payoff ($3.75) exceeds the maximum risk ($1.25), making this an attractive investment. If a decline in the stock price is something you're worried about, hedging with an upward bias collar is a sensible choice. STOCK MOVES HIGHER – PROFIT COLLAR Even while a collar is an excellent low-risk strategy adjustment to make when buying stock, it may also be an excellent low-risk follow-up adjustment if the stock has risen higher. Applying a collar to a stock that has gained in price is a means to lock in a profit and still participate in some of the upward movement of the stock up to the short strike, since the collar comprises of a protective put and a covered call. A profit collar describes this situation. In addition, the collar might increase the potential gain if it is installed for a credit.

Let's say you invest $100 in EBAY and then see it rise to $110, at which point the 3-month $115 Call option is trading at $5.50 and the 3-month $105 Put option is trading at $5.00. Adding a profit collar to the strategy requires selling the $115 Call for $5.50 and buying the $105 Put at $5.00, for a net credit of $0.50. Figure 3.17 depicts the revised risk/reward profile of the stock position after the profit collar was implemented. If EBAY drops below $105 before the option expires, you will make a minimum profit of $5.50. In this case, if the company is trading at $105, the put may be executed for a profit of $5.00, which would be in addition to the $0.50 credit gained from the profit collar.

When EBAY closes over the short strike price of $115, traders may make the most money. At that price, EBAY may be called away for $115, yielding a profit of $15.00, plus the credit of $0.50 from the profit collar, for a grand total of $15.50. Accordingly, you have guaranteed a profit of $5.50 to $15.50, depending on where EBAY is at expiry, simply by adding the profit collar to the EBAY stock position. In reality, you were compensated fifty cents for starting the profit collar.

Thus, you were rewarded for taking the precaution of securing a profit. Only including the protected put would have necessitated more funding for the put. If you combine the protected put with the covered call to make a collar, you may get the same effect without spending any further money. Assuming a minor deficit to institute the profit collar, you may be certain that your position will still generate a profit within a certain band. Let's pretend that instead of a net credit, the above profit collar was instituted for a net negative of $0.50. This trade would guarantee you at least $4.50 in profit ($5 put profit minus $0.50 debit), and it might make you as much as $14.50 in profit ($15 covered call strike profit minus $0.50 debit). Creating a profit collar with a net debit accomplishes the same goal of guaranteeing a profit and transforming a risky long stock position into a no-risk trade until the expiration of the collar, even though it would be optimal to establish a profit collar for a net credit to increase your guaranteed profit. Always keep in mind that there is no danger in the position until the options expire. When the covered call and protected put expire without any value, the risk associated with holding EBAY is once again exposed. It is up to you to decide whether to launch a new profit collar, make a new option modification, or just cash out at expiry and take the gains.

A profit collar with an upward bias, set at $110, might be added to the EBAY trade to ensure a larger minimum profit. To set up the upward biased profit collar for a net debit of $2.00, you can still sell the $115 Call for $5.50 but instead of buying an OTM put, you may buy the 3-month $110 Put for $7.50. By exercising the $110 Put at a profit of $10.00 and buying the profit collar for a net debit of $2.00, we reduce the minimum guaranteed profit to $8.00. Profit potential is limited to $13.00 ($15.00 gain from covered call minus $2.00 net debit). Due to the higher strike price of the protective put, the minimum profit from the upward-bias profit collar is larger. When compared to the basic profit collar, the maximum profit is lower because of the greater minimum profit. Figure 3.18 shows a comparison between the profit collar and the profit collar with an upward bias.

Once the stock price has increased, you may choose the strike prices for a profit collar. The strikes may be set to meet your demands for either minimum guaranteed profit or maximum profit. Common collars include out-of-the-money (OTM) puts and calls that are one strike away from the stock price, or an at-the-money (ATM) put and an OTM call. However, the strike prices may be shifted farther apart to provide varying risk/reward profiles.

We will not consider the adjustment of adding a collar to a stock which has moved lower, because a collar has limited upside profit potential.

Putting a collar on a stock that subsequently fell might lock in a loss with no further advantage to the investor. As risk management goes, this isn't very good. Since an example, if the price of If a If a collar was placed on a stock that has moved lower, then the collar might be locking in a loss with no added benefit. This is not a good risk management principle. For example, if EBAY fell to $95 and you created a collar position using a $100 sell call and $90 buy put, then you will only breakeven if EBAY moves above $100 because when it hits $100, you will be called out of the stock. If the collar is created on a slight credit, this is usually still not a good idea to lock in a loss when there are other option strategies available.