Hedge Strategy: The Collar Option
NAME: Collar Option AKA: Hedge Wrapper ANALOGY/METAPHOR:
ACTION: For each 100 shares of stock you own, buy 1 out of the money (OTM) put and sell 1 OTM call (covered call). The premium you receive on the covered call will more or less pay for the premium you pay purchasing the long put.
There is a drawback, however. You've creatively financed your insurance policy by agreeing to give up all gains the stock would generate if its share price exceeded the strike price on the short call (covered call). EXAMPLE: Imagine that you're going through a messy divorce, and you're afraid that your estranged spouse will gain access to your extensive portfolio and begin liquidating your long term holdings . . . Wait. Wrong example. If this is the case, you need a good lawyer more than you need a good option trading strategy. The classic example for an option collar hedge strategy is this: you're in a position where you've got stock, and maybe a lot of it, that you would be happy to unload. For whatever reason, you're unable or unwilling to sell it at the current time. Maybe there are tax considerations, maybe you've been granted the stock or it's part of an Employee Stock Purchase Plan and there's a minimum holding period. The collar option effectively locks your selling price into a pre-determined range. You'll miss out profiting on any large moves upward, but you won't get killed if the stock plummets either. So let's assume that The XYZ Zipper Company is trading @ $35/share. You bought 100 shares 11 months earlier when the stock was going for $17.50/share. You're thrilled about the 100% return, but with the company's quarterly earnings release scheduled in just two weeks, you're a bit nervous. You really want to hold the stock for a full year so you can pay long term rather than short term capital gains taxes. What to do, what to do? You're in luck. One month out, the 32.50 puts and the 37.50 calls are each trading for $1 per contract (no emails! This is a simplified example--and for the sake of simplicity, commissions are also waived). You purchase the 32.50 put and sell the 37.50 call. You pay out $100 and collect $100--the premiums cancel each other out. If the stock ends up on expiration day trading anywhere between $32.50/share to $37.50/share, both put and call options will expire worthless and you're free to sell at the final share price. Let's say the stock moves up $10 to $45/share. Your net proceeds on the collar option are $3750 ($4500 minus the $750 value of the $37.50 call option you previously sold and must now buy back). And if the stock moves down $10 to $25/share, your net proceeds are $3250 ($2500 plus the $750 value of the $27.50 put you previously purchased). In this example then, and as far as you're concerned, you've locked the stock into a predetermined trading range of $32.50-$37.50. VARIATIONS: Depending on the circumstances, you might be able to set up the option collar with a tighter range. If the stock is trading right on a strike price, you should be able to buy and sell your options right at the money(ATM). In such a situation, there's no question of a trading range--you've essentially locked in a final price. Your specific application of the collar option will depend on which metaphor your objectives are relying on. Are you trying to lock in a certain price to sell the stock on a future date? Or are you looking for cheap insurance and hoping/expecting the stock to gradually climb? OTHER: "Collar Option" makes sense as an option trading strategy name. The long put and the short call effectively function as a collar on the share price (And depending on your objectives and preferences, you can adjust the collar and make it tighter or looser.) This strategy is also known as a Hedge Wrapper. I'm uncertain of the origin of this name, although it sounds to me quaintly English. I picture a discarded candy bar wrapper stuck in the bushes of a country cottage. But not bloody likely, I'm sure.
|
