Nowadays, Stock options are one of the most powerful instruments modern finance offers us to manage risk. Unlike the common belief, options aren’t risky assets, or at least, they don’t need to be. Depending on the strategy you use, options can range from heavily speculative to highly conservative. The final result depends on your decision. Advanced investors often use options to protect their portfolios, to exploit market opportunities, and to speculate on price–rarely using naked positions. Inexperienced investors often buy naked out-of-the-money options, which offer more upside potential, but often expire worthless–which contributes to the wrongly formed idea that options are a risky derivative.
When effectively used, options help reduce the risk of our portfolio like an insurance contract does for our most valuable assets such as our home or car. A few weeks ago, we took a look at one of the simplest options strategies that helped us protect our portfolio against negative moves – a protective put (Going On Vacation? Just Buy Some Insurance First). With just one put option, you can place a cap on potential losses coming in a stock you own and protect past against a bear market. Today, we will add a call option to the protective put to build what is known as a collar, which is the most popular method of protecting portfolio value against market declines. A collar is even cheaper than the protective put, but unfortunately this comes at the cost of limited upside potential. Let’s take a look at it.
A collar is used when an investor owns some stock and wants to protect it against downside risks. For some reason, he may think the market will turn more volatile, which might increase the odds for a price decline. Under such circumstances, selling the stock would be the more conservative approach as it would immediately cap any losses, but sometimes it isn’t desirable as long as medium to long-term prospects are still bullish, transaction costs are high, and/or tax liabilities deriving from selling the stock are unfavorable. This way, the investor may opt to keep its holdings and buy some insurance instead.
The easiest way to buy insurance is through the purchase of a put option on the stock he owns. The put guarantees the investor gets at least the strike of the put option at maturity date. His maximum loss would be equal to the difference between the stock price and the strike price of the put, plus the premium paid for the option. Just think about your car. If it is stolen and you have it insured, the maximum loss you will incur is equal to the difference between the price you paid for the car and the insured value plus the insurance premium.
Unfortunately, insurance isn’t always cheap. The higher the probability of an accident occurring (in real life), or the higher the volatility (in financial markets), it will cost more to insure is, and thus, the price of the put option will rise. Under such circumstance, investors opt to sell a call option at the same time they buy the put as a way of financing its cost. When selling a call, an investor receives its premium, and if tweaking the choice of strike prices, he can set the strategy for zero out-of-the-pocket cash. In that case, cash received from selling the call covers at least the cash paid for buying the put. This is knows as a zero-cost collar.
A collar is definitely cheaper than a protective put because an investor exchanges upside potential for downside protection. The strategy increases the potential loss floor while reducing potential loss at the cost of capping upside profit. It is a cheap protective put, a very conservative strategy.
Now that we know the theory, let’s look into a real case. Please note that the prices I use here correspond to real market data taken some time ago and thus, doesn’t correspond to the current time. It’s just for the sake of explaining how you could build a collar.
Let’s suppose Apple is trading at $470. As we expect some volatility for the short-term, we want to protect our holding without selling it–just for a short period. A put option with strike at $460 expiring in 30 days is trading at $9.05, which is almost 2% of the stock price. In order to reduce this cost, we don’t mind giving up the upside potential for the sake of getting a cheaper protection. So, we plan to sell a call option with a strike at $480 with the same maturity date which trades at $7.45. Our initial outlay is then reduced from $9.05 to $1.60, and the maximum potential loss is also reduced from $19.05 to $9.05. To get this extra protection, you exchange unlimited upside for an upside potential capped at $8.40.
The following table shows a simulation for the depicted situation and adds an extra collar strategy in which there’s no cost to set it up: a zero-cost collar. You can play with strike prices to fit payoffs to your goals but just have in mind that a higher downside protection (reduced potential loss) always results in lower profit potential (less potential profit).
A collar just buys you time to surpass a volatile period in which you’re less confident about price direction. This way, you get cheap protection on your holdings while avoiding undesirable transaction costs and tax liabilities that would result from selling your positions.
Stay tuned with us for more on options strategies. We will be covering several options strategies you can use to profit from different market situations.
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