The Options Insider - Your Inside Source for Options Information

How To Hedge Your Stock Positions Using Collars

Hedging Your Stock with Collars
It is well known that you can hedge a stock by either buying a put or by writing a call on it. What is not so well known is that you can combine these two strategies. This long stock + short call + long put combination is known as a "collar."

As we shall show you with four different variants, this combination is really very flexible. In a coming report, we will show you the advantages and disadvantages of a different hedge, the 1-to-1 bear spread.

Hedging With A "Collar"
Usually, when setting up a collar (long stock + short call + long put), you write a near-the-money call on stock that you own and buy an out-of-the-money (i.e. lower strike) put on this same stock. On a net basis, if the call strike price is closer to the stock price than put strike price, you will take in premium.


As with a covered call, you can earn money even if the stock stands still. In addition, you will be protected by the put. Even if the stock goes to zero, your loss is limited with this collar to the difference between the stock and the put strike price minus the net premium you took in.


CLICK HERE FOR THE FULL-SIZED IMAGE

In Graph 1 , we show you an example of hedging 100 shares of Apple Computer (stock price = $65.00) by writing an at-the-money July $65.00 call at $4.70 and buying an out-of-the-money July $55.00 put for $0.90. With this combined hedge, we take in a net premium of $3.80 per share ($4.70 minus $ 0.90) or $380 on 100 shares before commissions. (For ease of discussion, we will exclude commissions.)

In the graph, we show the likely "mark-to-market" P/L of these combined positions on three different dates. These dates are (1) the day the position is established, half way to the expiration and at the expiration of the options.

With this collar, your maximum profit is $380 if the stock ends up at $65.00 or higher. The most you can lose in this example is $620 if the stock ends up at $55.00 or below at expiration. In addition, because of the $380 credit, you have a break-even point of $61.12, $3.80 below the current $65.00 stock price.

continued in Part Two...

posted by: Value Line Daily Options Survey