On Monday a client asked me for my take on an article in BusinessWeek about option collars. We talked a little about the strategy but I didn't get around to reading the article until today.
If you don't know the term, a collar refers to buying a stock, selling a call option and using the premium taken in from the call to buy a put. Depending on the stock and the option premiums, you might be able to have no out of pocket cost for the option combo part of the trade.
The article has a table with several different examples. I'll look at the first one which is Dell Computer (DELL). I'll just repeat the stale prices in the article, this is just for examples' sake after all.
Buy 100 Shares DELL $29.42
Sell 1 Call Jan 2007 struck at $35 for $1.30
Buy 1 Put Jan 2007 struck at $27.50 for $1.70
There is a net debit of $0.40 plus commissions. For that $0.40 you will have a maximum gain of 17.4%, a maximum loss of 7.8% or anything in between.
The article is based on work by a money manager named Thomas Schwab (no relation). The article delves into Schwab's philosophy and makes the trade sound compelling.
Like all strategies, there is a downside which you probably know is you give up potential upside above the strike price of the call. I think it goes deeper than that though to really understand what that means.
The article opens with anecdotes about the recent slide in Google and the GM bankruptcy scare as reasons to consider using collars. I felt like the tone of the article was to look at this in the context of every stock you own being a stand-alone investment.
I think this is a bad way to think your portfolio. If you had only ten stocks and collectively the ten were up 20% vs. the market up 12%, would you care if one stock was down 15%? Perhaps you got 20% by having one stock double, one stock go up 50%, seven of them flat and the one loser ( I don't know if the math is right, it's just an example).
If you sold a call 17% out of the money on the one that ended up doubling, that 20% portfolio gain looks a lot different.
One way to think about using this trade, if you can't resist, might be to collar a portion of the position. If you are a 300-share buyer, maybe just collar 100 shares? This not really my type of trade and collaring a portion might not appeal but if you collar the one stock that doubles you will likely regret the trade.
Wikinvest Wire
3 comments:
I've only ever used collars once; when I had a position that I intended to liquidate to use as the downpayment on real estate and did not want to incur a substantial loss. I don't remember the details - it was in 2000/01 - but the stock was more or less flat with the call WAY out of the money and the put close to, but the option trade was nicely profitable. I do remember that the stock was MMC which got Spitzered in October 2004.
Apropos of nothing at all, I lost the house in my divorce in 2003 and ended up with the stock. Doubtless these days there's an option strategy to cover that as well.
Roger,
I am a regular reader of your blog and enjoy it immensely. Keep up the good work.
On the subject of collars, I had a related question. Have you tried using conversions. The trade is similar to a collar except that the buy and call are at the same strike price and the trade should result in a net credit. Essentially, you have a neutral position on the stock and your profit is the credit you earned on the option trade.
I have come across couple of situations where this was possible (the net credit part) and I could not believe that there was money on the table for taking with no risk. Am I missing something here?
Thanks !
conversion? don't know the term.
If you are buying a put and selling a call (this is not clear from your comment) with the same strike for a credit are you doing this at the money?
If I have that right then, as you say, are neutral on the stock I suppose. The return would be like an enhanced money market.
If you do that on a stock that sky rockets you would be giving up a home run for a base on balls.
If, emotionally, you really are willing give up the upside for a fat money market.
If you really want to explore this as a strategy instead of buying the stock, but a deep in the money call with no time premium. On an $80 stock that isn't hyper-volatile, you might have to go $30 in the money. Then put the other 50 points in the money market.
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