So You Want To Trade Options/Strategies

The Dos and Don'ts of Collars
Elizabeth Harrow (eharrow@sir-inc.com)

Let's take a look at collars. This two-pronged strategy can help you limit risk on stock investments, just like a protective put -- but a collar is a slightly more sophisticated tactic. Don't worry, though: if you know what you're getting into, even a novice option trader can successfully implement a collar.

Feeling anxious?

First and foremost, I should explain that a collar is an option strategy to be used in conjunction with an existing stock investment. In other words, this is not a stand-alone strategy -- think of it as more of an accessory to another trade, if you will.

collarSo, let's say that you're an investor in the fictional company Zoological Flu Vaccines Unlimited (ZFVU). What with the H1N1 virus blazing a path around the globe, the shares of ZFVU have skyrocketed to a gain of 500% in 2009. You purchased 100 shares at $2 a pop back in January, and they're now worth $10 each.

You're certainly pleased with yourself, as you should be, but now you're nervous. With flu season on the horizon, you're wondering if the stock's rally has reached its peak. You don't want to get greedy and end up losing your handsome profits, but you wouldn't mind eking out just a bit more upside, if you can manage it. What to do?

Well, try your hand at a collar, of course! To build the trade, you will simultaneously buy to open one out-of-the-money put, and sell to open one out-of-the-money call. By doing so, you will lock in your right to sell 100 shares of ZFVU at either the strike price of the put, or the strike price of the call, depending upon which option goes in the money first.

collarEssentially, these two strike prices will determine your two possible exit prices for the stock investment, so keep that in mind when you're selecting your options. In this example, you might buy a put at the 7.50 strike, and sell a call at the 12.50 strike. This will allow you to take part in any gains up to $12.50 per share, while ensuring that you'll be able to unload the shares at no less than $7.50 apiece, should ZFVU take a dive.

You can think of this strategy as the combination of a protective put with a covered call: the purchase of the put option limits your downside risk, while the sale of the call option caps your potential profit.

So, why not just buy a protective put? Well, the sale of the call option in a collar strategy will reap you a premium upfront. Depending upon the specific situation, this initial income can offset the cost of the purchased put either partially or entirely. This allows you to protect your paper profits on the cheap -- or even for a minor profit, if you can manage it.

In any event, it's fair to say that you shouldn't run a collar trade if you really, really want to hang onto the underlying stock. Generally, traders who play collars are happy with the performance of their stock investment, but they're just about ready to move onto new opportunities. Think of this strategy as a two-pronged exit plan, and then execute it appropriately.

A few potential outcomes

So, let's say that your worst-case scenario came to pass, and ZFVU nose-dives down to $5 per share by the time your options expire. Such a decline would have whittled your profits on the stock trade away to just 150% -- still good, but a far cry from 500%. However, since you availed yourself of a protective put, you decide to exercise your option. You sell all 100 shares of ZFVU for $7.50 apiece, bringing your total profit on the stock investment to a respectable 275%.

In this situation, your sold call would obviously expire worthless, and you would have to take no further action to close it out. The collar effectively limited your downside risk, and guaranteed you a favorable exit price.

collarAlternatively, let's say that a new animal-related flu swarms the globe, and ZFVU catapults to $20 per share as analysts laud its new goldfish flu vaccine. You'll most likely be assigned on that sold call option, forcing you to cough up 100 shares for $12.50 apiece. In this scenario, you will have netted yourself a profit on the stock investment of 525%. Meanwhile, your purchased put will expire worthless, having served its purpose nobly but uselessly.

While no one ever cried himself to sleep over a 525% profit, there is a downside here -- you lost the opportunity to ride the stock's uptrend all the way up to $20 (and possibly beyond), which would have fattened your bottom line even further. I would consider this to be a relatively minor downer, but more aggressive traders will no doubt be kicking themselves.

So, let me say this in boldface: If you don't want to limit your upside potential on the stock investment, don't use a collar. You may still use a protective put if you're feeling hedge-y, of course, but don't feel obligated to sell a call just because I said you could. Unless you're truly comfortable taking profits and exiting the trade at the strike price of the sold call, the collar may not be appropriate.

Finally, there is a third potential outcome here. The stock could do absolutely nothing during the time frame of your trade, leaving both options to expire worthless. What you do from here is your own business, but it's probably a good time to reexamine your initial rationale for the trade. Has the fundamental backdrop changed? Are the technical drivers still in place? What about the prevailing sentiment toward the stock?

After you've assessed these factors, your next step may or may not be obvious. A few alternatives: sell the stock; buy more shares; play another collar in the next available option series; or simply ride it out and see what happens next. In any event, it's good to know that you have a handy new option strategy in your back pocket, ready to deploy whenever circumstances dictate.


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