How To Hedge Your Stock Positions Using Collars - Part Two
...continued from Part One
A "Costless Collar"
Another typical configuration of a collar is what is known as a "costless" collar. Here, you buy an out-of-the-money (lower strike) put on the stock and sell an out-of-the-money (higher strike) call for about the same amount of premium.
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Graph 2 shows an example of a "costless" collar. Here we hedged our 100 shares of Apple by writing the January 2008 $75 call for $9.95 and buying the January $65 put for premium of $10.30. This combination gives us a small net debit of $0.35 (or $35 on 100 shares).
Notice the advantage of this costless collar, since you get $1465 worth of upside ($80 Call Strike minus $65.00 stock price minus $0.35 net premium paid) in return for a maximum loss of only $0.35.
Often the way option premiums are priced can add to the attractiveness of these "costless" collars. This is especially true for longer-term options when the interest rate factors make out-of-the-money call premiums higher than many put premiums.
A "Diagonal Collar"
You may choose instead to buy a longer-term lower-strike put and sell a shorter-term higher strike call to round out your collar. In Graph 3, we have written the out-of-the-money July $70 strike call at $2.60 and we have bought a January 2008 $65 put at $10.30.
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This hedge benefits from the slower time decay of the longer-term option. Thus, on the July expiration date, if the stock is still at $65, you will have kept the call’s entire premium while the long put will still be worth a large part of its original value (assuming no decline in implied volatility).
One important note about this diagonal hedge: notice that you achieve your maximum profit if the stock price ends up at the short call’s $70.00 strike price. Above that strike the gains get narrower, owing to losses in the long put. Indeed, it is possible to actually lose money if the stock rises far enough.
A Truly Bearish Collar
You can even construct your collar so that it gives you a bearish exposure to the underlying stock. Graph 4, we have sold a deep in-the-money July $55.00 strike call at $11.35 against the stock and bought a deep in-the-money July $75.00 put at $10.95.
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These two transactions more than offset the effects of owning the stock, creating a net bearish position. Such a collar can be useful in accounts (such as some IRAs) in which investors are restricted from taking outright bearish positions.
POSTED BY: VALUE LINE DAILY OPTIONS SURVEY
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About Lawrence D. Cavanagh
Lawrence D. Cavanagh is Editor (and Senior Analyst) of The Value Line Daily Options Survey. The Value Line Daily Options Survey offers evaluations and rankings on virtually the entire universe of regularly listed equity and ETF options, using the Value Line common stock ranks and proprietary volatility forecasting methodology. Before joining Value Line in 1991, Mr. Cavanagh was an options strategist for Capital Market Technologies (subsidiary of Elders Finance), helping design long-term synthetic foreign currency and gold option hedges. Before that, he was Director of Foreign Currency Options for the Chicago Board Options Exchange. Other work experience includes Dean Witter Reynolds (VP, Senior Currency Analyst), European American Bank (Director of Currency Forecasting) and the Federal Reserve Bank of New York (Assistant Economist).
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