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I strongly believe that a collar (buy stock, sell call, buy put) is one of the best trading positions a trader, whether novice or experienced, can place. It can be used to hedge long term investments such as a stock portfolio or it can be a source of generating income in a fairly safe manner. The example I am going to use is a plain vanilla collar on AAPL, as I could have just as easily used one of the bigger and more volatile stocks such as CME or GOOG with more dramatic results.

The point is that I am not trying to sell you on this strategy, but rather give you an overview as to how this method can be used. This strategy sells itself. Do not mistake this article as a do-it-yourself recipe by which you can go out and start trading like a pro. As a matter of fact, the example I am using here left so much money on the table that any professional trader would be embarrassed to claim that he did the trade as described. Many multiples of what was made could have been actualized had it been done correctly.

I titled this article “The Lazy Stock Collar” because we will only be trading on expiration day right at the close. In other words, in all but the month of April we will put the trade on and ride it to expiration. On expiration we will adjust it out to another month.  April is an exception as I just wanted to demonstrate how much could be made by dynamic hedging.

The purpose is to show that AAPL did not move considerably from expiration to expiration, yet this trade vastly outperformed that of the traditional “buy and hold” technique most mutual fund salesmen and brokers try to convince one to do. This is the power behind options though the example could be considered trading in a coma-like condition as you only need to be awake for 5 minutes a month. If your version of narcolepsy is more severe, I don''t know what else I can do to show you how little work option trading can be.

Quick Definition 

Collar – A collar is a position in which the trader owns stock and purchases a put for protection much in the same way the owner of a home buys insurance in case of catastrophe. As the protective put costs money, the trader may elect to sell a call option and give up some potential upside profit in exchange for the put being paid for (in whole or part).

Assumptions

As the primary focus here is not criteria, but rather illustrating how the concept works, I will be taking many liberties here in order to save on math and work within the confines of the space allotted to me. In other words, we will putting the trade on at the moment of February expiration for the following month, thus using March options (as the February options are expiring in seconds). In addition, because we will be usually selling a call and buying a put about the same distance OTM from each other, both options will be about the same price in our example. See the option chain of May 16^th where the stock closed almost right at the strike:

Figure 1: AAPL Chain

In real life, there are times when the collar will cost money and other times when you may do a collar for a credit. In this example, we are going to assume that if we bought a put for $1 we will sell a corresponding call the same distance OTM at $1, thus the collar was placed for no money. I realize that this is an over simplification, but the math over the long run may be about the same. I also do not have the space to cover complicated accounting of credits and debits, and more importantly it will make following the example much easier. A clean example would require a minimum of 20 pages and my editor has shot people for anything over 4 pages.

The Trade

We will place the collar for a period of 5 expiration cycles. We will only actively hedge one month to illustrate the power of the trade both when viewed as actively managed and left alone to do its own thing. We will be buying puts and selling calls “roughly” about the same amount OTM over the long run. Sometimes the trade will look rigged in our favor and sometimes against us. Please bear with me.

We will begin by purchasing 1,000 shares of AAPL stock on the close of expiration February 17^th for $70.29 and buying the March 70 put and selling the March 72.50 call for about even money. Again, in this example we would likely have to pay a little money out as the put is closer to ATM than the call, but it will balance out by the end of the study. We will take the trade off July 21st expiration by selling the stock at $60.72, or a loss of $9.57 (13.6% loss in 5 months). Had this position been a buy-n-hold, we would lose over 13% on the trade. Keep this in mind as you look at the collar.

Trade #1 (February 17, 2006)
Buy 1,000 shares of stock for $70.29 ($70,290 cost)
Sell 10 March 72.50 calls
Buy 10 March 70 puts

Trade #2 (March 17, 2006) Stock is at $64.66
Stock = Leave Alone
March (Closing Trades)
March 72.50 calls expire worthless
March 70 puts are $5.34 ITM and can be sold to collect $5,340.

April (Opening Trades)
April Buy 62.50 put
April Sell 65 call
Note: this is one of the collars that you would have been able to receive a credit for.

Figure 2: Lazy Collar

Trade #a. (March 29^th) Stock at $57.67 intraday
Illustration Only

We will not do this trade but show it as an example of dynamic hedging. We can either sell our put out or leave it alone and do nothing until expiration. As we own the $62.50 put we will sell it out for intrinsic value (we will ignore time value) and collect $4.83 a share. This will put $4,830 in our pockets. The call is almost worthless so we can buy it back for $0.05 (or $50). We now have a total of $10,390 in our pockets from the sale of puts. We would put on new collars now. We will not take this money, but rather leave it on the table as we will only trade on expirations. 

Trade #b (April 6, 2006) Stock at $71.24
Illustration Only

Again we will do nothing here as it is not expiration. In real life when not trading in a coma or from the Congo we would have re-hedged at #a. As the stock ran up we would be rolling our whole collar (both call and put) up and here we may have elected to buy a higher put and sell a higher call. This would make us A LOT of money after the sell off that is about to ensue (see chart), but we will do nothing. Also, as the stock begins to run up, we can do a trade called “rolling up and out” to move up strikes without putting more money out of pocket from the front month call going up in value. Again, too complicated for this article, but let''s say we did roll the calls and puts up 1 strike to the 67.50 call and 65 put as the stock ran up. Expiration is approaching. 

Trade #3 (April 21, 2006) Stock is at $67.04

Had we been taking advantage of the movement in the stock (see Figure #2) we could be in a very good position to make a lot of money on this position. As it turns out this example is being done when we only trade on expiration days. We will be leaving a potential fortune on the table, but I do not have the room to explain the right way to trade this, and if you do not do it the wrong way it could be disastrous. 

In step #b we didn''t take advantage of all the intrinsic value in the puts but we did get nervous and roll the position up to where we have the following:

Stock = Still long 1,000 shares for $70.29
Closing Trades
April 67.50 call = expires worthless
April 65 put = expires worthless

Opening Trades

As it is another expiration, we will have to re-hedge again. With the stock at $67.04 we will buy an OTM put and sell and OTM call the best we can. Again, things are not always perfect so we decide to buy the 67.50 put and sell the 70 call as the market has been going up and we want to leave room for capital appreciation, right?

May Opening Trades
May Sell 70 call
May Buy 67.50 put

Trade #4 (May 19^th) Stock closes at $64.51
May Closing Trades
May 70 call expires worthless
May 67.50 put is $2.99 ITM and is worth $2,990 profit

As we have collected $2,990 for this trade and $5,340 (Trade #2) we have a total of $8,330.

We can now use this to buy more shares of stock in 100 share blocks (for hedging purposes). We purchase 100 shares more (for a total of 1,100 shares), which costs us $6,451 and leaves us with $1,879 in cash. We now have to use 11 collars instead of 10 as we have 1,100 shares of stock.

Opening Trades
By 11 June 62.50 puts
Sell 11 June 65 calls
Shares = 1,100
Cash = $1,879

Trade #5 (June 16, 2006) Stock closes at $57.56
Closing Trades
June 65 calls expire worthless
June 62.50 put is $4.94 ITM which is worth $4,940
We can now buy more shares as we have $1,879 in the bank for a total of $6,819.
The stock is purchased for $57.68 which leaves us $1,051 in the bank.

We purchase another 100 shares for a total of 1,200 shares, and need 12 collars for hedging.

Opening Trades
Buy 12 July 55 puts
Sell 12 July 60 calls
Cash on hand = $1,051

Trade #6 (July 21) Stock closes at $60.72

We can look at this two ways. Either we took a small loss on the calls with intrinsic value or we rolled the collar. In a real scenario, we would likely want to roll the collar up as the stock advances, but let''s say we didn''t have time and got caught. Or we can say we just didn''t look at the trade until expiration so we lose $0.72 intrinsic value on expiration with the calls.

Closing Trade
July 60 calls lose $0.72 per share, or ($864) which brings our bank down to $187.
July 55 puts expire worthless.

Still long the 1,200 shares of the stock as we bought back the calls at a loss.

Opening Trade
Buy Aug $57.50 put 12 times
Sell Aug $62.50 call 12 times
OR CLOSE THE POSITION


Figure 3: AAPL

Conclusion

We are now hedged again going into August expiration. At the end of these five months we have 1,200 shares of stock trading at $60.72 for a total value of $72,864 plus a cash balance of $187 for a grand total of $73,051 in cash and stock.

We started with only $70,290 but now the account is at $73,051, a $2,761 PROFIT despite the stock being down 13%.  In other words, the power of this strategy is that you have hypothetically made 4 % in 5 months on a stock that is declining. Had the stock been in an uptrend, the results may have been even more astonishing!

What is even more powerful, besides the fact that you didn''t lift a finger for more than 5-15 minutes a month, is that when looking at figure #2, the stock bounces back to almost $68 at the end of August expiration. If you are still long the 1,200 shares of stock at this point, you will be up serious money despite the stock being down about 4% from where you bought it.

Even more exciting is that you left so much potential money on the table that most traders would be sick with themselves. Though this is a hypothetical trade, I know of one trader who had this position on, and no...it wasn''t me. I was playing this name but using a different strategy myself.  

Please, do not try this at home without the proper education. It looks complicated on paper but exciting from a potential reward perspective. Like so many things in life, once you know the right way to do the trade it is easy, but there are many wrong ways to do something and really only one right way.

Many variables need to be considered when selecting the stock, the month to hedge with, the strike price, when to tighten up or expand the collar, when to roll the collar up or down, when to take the trade off, etc.  I have seen entire books dedicated to just this trade.  As you may have heard the saying, “It is simple, but not easy.” Yes, once you learn the proper way to trade this, it is one of the most relaxing, safe and profitable trades around. Until then, you are attempting to build a house with a power saw and have no instruction. I don''t want to see you lose a finger. Rest assured though that option trading is the way to go. The buy and hold trader would have had an ulcer and a loss. Your option knowledge will pay off.


Scott Kramer
Staff Writer and Trading Strategist
Optionetics.com ~ Your Options Education Site
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