Fashion comes and goes but there are some items that never go out of style. They simply are classics. The same could be said of some option strategies which never go out of style. Although the market has dropped lately and maybe your investments have gone down in value, it may still make sense to consider a collar.
A collar strategy is an option strategy that can particularly benefit investors. In this blog we generally have a lot more options education for traders and less for long-term investors. So a collar is a strategy that both can consider. A collar is simply holding shares of stock and buying a put and selling a call. Usually both the call and the put are out-of-the money (OTM) when establishing this option combination. A basic single collar represents one long put and one short call along with 100 shares of the underlying stock. A collar strategy is frequently implemented after stock (investment) has increased in price. The main objective of a collar is to protect profits that have accrued from the shares of stock rather than increasing returns. Is that an option strategy you might consider? Let’s take a look.
Why a Collar?
Since the market has been declined after trading relatively sideways for several months, there are a plethora of stocks that have decreased in value but are still profitable on the P/L ledger. But what if the market and your investments continue to decline? One option strategy is to buy a put. The investor has some protection for the unrealized profits in case the stock declines. The other part of the combination is selling the OTM call. By doing this, the investor is prepared to sell his or her shares of stock if the call is exercised because the stock has moved above the call’s strike price.
The advantage of a collar strategy over just buying a protective put is being able to pay for some or the entire put by selling the call. In essence, an investor buys downside stock protection for free or almost free of charge. Until the investor exercises the put, sells the stock or has the call assigned, he or she will retain the stock.
Volatility and Time Decay
Implied volatility (IV) has been really high over the last several weeks in the market with this recent decline. Although it is advantageous to sell options when implied volatility is high (selling the OTM call), volatility and also time decay are not usually big issues when it comes to a collar strategy. The simple explanation is because the investor is long one option and short another so the effects of volatility and time decay will generally offset each other.
An investor could have bought 100 shares of Delta Air Lines (DAL) in October of last year for about $32 a share. Like many equities, the stock declined but at the time of this writing, the stock has climbed back to about $46 a share and the investor is still worried about the current market conditions and protecting his unrealized gains. The investor can utilize a collar strategy.
The investor can buy an October 42 put for 1.20. If the stock falls, the investor will have the right to sell the shares for $42 up until October expiration. At the same time the investor can sell an October 48 call for 1.45. The $48 area has provided some resistance in the past for the stock. This will make the trade a net credit of 0.25 (1.45 – 1.20). If the stock continues to rise, it can do so for another $2 until the stock will most likely be called away from him.
Three Possible Outcomes
The stock finishes over $48 at October expiration. If this scenario happens, another $2 per share is realized on the stock and $25 on the net credit of the combination is the investors to keep.
The stock finishes between $42 and $48 at October expiration. In this case, both options expire worthless. The stock is retained and the $25 net credit is the investors to keep.
The stock finishes below $42 at October expiration. The investor can sell the put option if he wishes to retain the stock or exercise the right to sell the stock at $42. Either way the $25 net credit is the investors to keep.
The nice thing about a collar strategy is that an investor knows the potential losses and gains right from the start. If the stock climbs higher, the profits may be curbed due to the short call but if the stock takes a dive, the investor has some protection due to the long put and having protection might not be such a bad idea if the market continues to be weak. See…even an investor can benefit from some options education!
Senior Options Instructor