Posted by: Tyson Heyn | September 6, 2009

Using Options for Cheap Protection: The Collar

Figure 1: Recent AAPL Performance.
Figure 1: Recent AAPL Performance.

I’d like to introduce a simple and straightforward way to use options to inexpensively protect an investment.  This method–known as the collar–essentially establishes a trading range for a stock in your portfolio, which is good over a period of time of your choosing.

Suppose you own 100 shares of Apple Computer (AAPL) stock and have realized a very nice gain.  You are tempted to now take profits but believe that the upcoming Christmas season could push the stock higher.  On the other hand, something disastrous could happen (e.g. Steve Jobs heading to that great big Macintosh in the sky), which could suddenly and swiftly punish the stock, leading you to believe that protection from such a liability is warranted.

It’s always a good idea to first see what a stock’s recent price action can teach us.  In Figure 1, we see that the shares have enjoyed a very nice gain (priced at $170.31 as of Sep. 4, up 99% for the year) and find support at $160 (green line).

The conventional approach for protection is to establish a trailing stop sell order–in essence, you pick an amount of decline you’re willing to accept in a stock, and anything more than that triggers an immediate sell.  The upside to this approach is that if the stock continues to rally higher, the point at which your sell order will be realized rises in tandem with it.  For example, if you set a sell order for AAPL with a trailing stop at $10, the stock will sell as soon as it hits $160.31–but if the stock moves to $180, your new trigger is $170.

I like trailing stop sell orders, but I only use them when exiting a position with no plans to re-enter the stock.  That wouldn’t serve my needs in this case since my hypothesis is that AAPL might rally through the Christmas season.  If AAPL even simply hit a period of volatility (it is a high beta stock, after all), my trailing stop sell order might be prematurely fulfilled.

Establishing a collar guarantees a floor and ceiling on the share price through the expiration date of your choice.  Expiration dates are typically on a monthly and/or quarterly basis, occurring on the third Friday of the given month.  So, if I’m looking for protection today through Christmas, I might consider the January 16, 2010 options expiration time period.

Options are typically offered in units that each cover 100 shares of stock.  So, my lot of 100 AAPL shares will nicely match up with one call and/or put, depending on what I’m trying to do.

A put is a contract entitling me to sell a stock at a certain price through the expiration of the option.  So, I might buy one put (which covers 100 shares of stock) for AAPL in the January ’10 expiration period with a strike price of $160.  That means that no matter how low AAPL’s stock is on January 16, 2010, I can still sell it for $160.  Did it fall 100 points to $70/share?  Fine with me–I’m still selling at $160, since that’s the floor established with my put purchase.

Of course, if AAPL closes out January 16 at $300, my put is worthless.  The current market price would be far above the strike price, so I’m better off holding onto my stock than exercising this option.  (Most brokers will automatically make the best choice for you, while you retain the option to give them instructions that override their judgment.)

To get this put–essentially, guaranteeing me a floor of $160 for my 100 shares of AAPL stock through the January 2010 expiry, I have to pay $1,050.

Sticker shock!?  Most likely.  While my 100 shares of AAPL are worth $17,031, paying 6.1% of their value to protect them against a 5.8% move for a finite period of time may seem like a bad deal.

Part of what makes the deal worthwhile is the fact that you can sleep well each and every night while under put protection, not having to worry about what tomorrow will bring.  Think of how many folks wished, in hindsight, that they had purchased puts for their stocks before the 2008/9 market meltdown.

In any case, the better news is that financing is available.

A call is a contract entitling me to purchase a stock at a certain price through a certain time.  So, if I buy a call for AAPL stock with a $180 strike price and January 2010 expiry, I’ll be able to purchase 100 shares of the company at the given price at any time between now and expiration.  AAPL trading at $300 on January 16?  Great–that’s a $120 discount that I’ll enjoy.  What about AAPL at $70/share?  I simply don’t exercise the call option, and I can buy the stock at that day’s lower market value.

In the case of a collar, instead of buying a call (I already own the stock, after all), I’ll sell a call.  That means that I’m willing to part with my shares once the stock rises above a certain price point.  Since AAPL is at $170.31 today, selling a call against my shares with a $180 strike still allows for a potential 5.8% profit while collecting the guaranteed premium from selling the call.  And how much is that premium?  $1,082, thank you very much!

Hmmm…so we just looked at holding 100 shares of AAPL stock, buying insurance for $1,050 to guarantee a floor of $160 on the stock price through expiration, and then selling possible upside on the stock for $1,082, which caps our profit if/when AAPL moves beyond a $180 share price.  Minus commissions, that’s just about break-even. ($1,082-$1,050-your broker’s transaction fees=$0ish.)  Congratulations, you’ve just established your first options collar!

To get a better feel of what happens to your investment, I’ve posted some charts to walk us through profit/loss scenarios.  Owning the stock without any options play looks like this:

Figure 2: Owning 100 shares of AAPL stock.

Figure 2: Owning 100 shares of AAPL stock.

The dashed lines walk us through time. “Time decay” is essentially the effect of an investment losing value over time. An extreme example is owning a 2008 Ford F-150 pick-up truck–I guarantee it’s not worth as much as when you bought it. (Someone please tell those folks who sell their year-old vehicles in the Classifieds.) Owning the stock while simply buying the aforementioned put results in this:

Figure 3: Straight AAPL ownership (green) vs. stock & put (blue).

Figure 3: Straight AAPL ownership (green) vs. stock & put (blue).

The green lines show us, again, the results of simply owning stock from now until January 16, 2010, while the blue lines highlight a stock plus purchased put combination.  Notice the floor that’s established at the $160 price point–you cannot lose more than that.  Notice, however, that your break-even line shifts from the present value of $170.31 to $182.74–ouch!  Better look at selling some calls to get this picture back in order:

Figure 4: Straight AAPL ownership (green) vs. stock & put (blue) vs. collar (red).

Figure 4: Straight AAPL ownership (green) vs. stock & put (blue) vs. collar (red).

The red designates the collar (note the floors and ceilings) while the green and blue represent the previously disclosed stock-only position and stock-put combination, respectively.  A little more cleanly, at expiration, the setups would look like this:

Figure 5: Straight AAPL ownership (green) vs. stock & put (blue) vs. collar (red).

Figure 5: Straight AAPL ownership (green) vs. stock & put (blue) vs. collar (red).

Note that the profit/loss line is now nearly identical between straight stock ownership and owning the collar.  The only material difference is that floors and ceilings have been introduced.  Finally, the collar all by itself:

Figure 6: AAPL January 2010 Collar

Figure 6: AAPL January 2010 Collar

Note that the change in valuation to this collar occurs more dramatically the closer time approaches the expiration date.  This means that if AAPL stock enjoys a sudden rally to $180 in the next week, it may be worth sliding your puts and calls accordingly to lock create new upside targets.  The cost should be nearly negligible.

Also, note that I can adjust my strike prices for my collar according to what kind of risk I’m willing to take.  While the $180/$160 collar we’ve reviewed effectively pays for itself, so does a $190/$150 collar.  Or, let’s say you don’t mind paying a bit more now not to limit your future upside, you can set up a $190/$160 collar for a cost of about $310.  Again, options are like LEGO–build with them what you want.

A few extra notes: most stock brokers (E-Trade, TD Ameritrade, et al) require approval to trade options, and they’re offered in four steps.  “Level 4” is most desirable, but you can also do the most damage to yourself, so upgrades typically come only every 90 days.  The upshot is that if you ever think you’ll trade options, start requesting options upgrades now.

It’s also important to note that Level 4 also requires margin.  So, if you’re trying to use options in your IRA or 401(k) account–where margin isn’t available–so Level 3 is as high as you can go.  For the most part, this isn’t terrible, and the rule is in place to ensure you’ll have something left for retirement.  Contact your broker to learn more about what each of the limit levels entail.

Further, keep in mind that a lot of these trades can be made in tandem–collars, call/put spreads, etc…  So, in the case of our collar, instead of having to first pay $1,050 for the put and then collecting $1,082 for the call,  you can simply specify the desired spread between the two that you’re willing to pay or receive in payment.  (At your broker, this is called net debit or net credit.)

In any case, I encourage you to evaluate your portfolio–especially as we enter into the historical “scariness” of September and October market drops–and see how collars can keep you safe during this spooky season.  Happy trading!

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Responses

  1. Nice blog with some solid info.

    Have a good one,

    Shanky


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