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Breaking down a hypothetical trade on GMCR
Keurig Green Mountain Inc (NASDAQ:GMCR) has been stair-stepping its way higher since the beginning of the year, and is up roughly 85% in 2014. Even as the broader market has turned lower, the stock -- currently trading around $140 -- has maintained its perch near record-high levels. However, since past performance doesn't necessarily guarantee future performance, a shareholder could find herself nervous in the run-up to GMCR's fiscal fourth-quarter earnings report, expected between Wednesday, Nov. 19, and Tuesday, Nov. 25. The question, then, is: How can options be used to reduce risk?
There are several potential answers to that question, but the one we'll be looking at today is the collar. This options strategy involves selling to open an out-of-the-money (OOTM) call, and buying to open an OOTM put. In other words, you could look at it as a combination of a covered call and a protective put, with the credit from the former helping to offset the cost of the latter. That being said, let's walk through a hypothetical collar in order to understand the strategy better.
To help us in this exercise, we'll start with an imaginary trader named Betsy. Betsy bought 100 GMCR shares for $120 each in July, and she remains bullish. However, she'd also like to protect her unrealized profits against a potential downturn over the next few weeks. Therefore, she sells to open one November 150 call (essentially, a covered call) for $4.60, and buys to open one November 130 put (essentially, a protective put) for $4.85. By simultaneously selling to open the call and buying to open the put, Betsy reduced her entry price to a net debit of $0.25 for the pair of contracts, or $25 total (net debit * 100 shares per contract). Had she just bought the put, she would've shelled out $4.85, or $485.
By initiating the puts, Betsy has ensured that no matter how far GMCR tumbles from now through the close on Friday, Nov. 21 -- when the back-month options expire -- she'll be able to sell her shares for $130 each. In other words, she'll make at least $10 per share, less the net debit for the options.
However, while writing the calls reduced her entry price, it also capped her maximum potential profit. Specifically, if GMCR surges north of the 150 strike during the next month, Betsy could be assigned, and be forced to deliver the shares for $150 each and miss out on additional portfolio gains. In other words, her maximum potential profit is $2,975 -- ([$150 less $120 purchase price] * 100 shares) less $25 net debit.
To further clarify the collar strategy, let's consider a pair of potential scenarios. Suppose, for example, GMCR plummets to $100 before November options expiration. In this case, Betsy would simply exercise her long puts to sell the shares at $130 apiece, while her short calls would expire worthless. In so doing, she'd still make $1,000 from the stock ([sale price less purchase price] * 100 shares), less the net debit for the options, for an overall profit of $975. By contrast, had she not initiated the collar, Betsy would be staring at a loss of $2,000 ([stock purchase price less current price] * 100 shares).
On the flip side, imagine shares of Keurig Green Mountain Inc (NASDAQ:GMCR) finished at $140 at expiration, unmoved from current trading levels. In this case, Betsy's call and put would both expire worthless, and she'd simply part with the initial net debit and hold onto her shares.