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Overview

The stock market has seen some solid gains during the past six months, sending the major market indices to multi-year highs. Now that we have experienced strong gains in the indices, it’s time to think about protecting these gains. Options are a great tool to help reduce risk and with this new series we plan on showing traders how to lock in profits by using a collar.

Once a stock or index has made a trader nice paper profits, there are a few choices that can be made. The first is to just continue to hold the security long term. Second, we can sell the security and take in the profits. Third, we can use a collar to lock in gains without the need to sell the stock. We often see stocks rise, consolidate or retrace some of these gains, then move higher in the future. A collar protects us from sharp declines in the security without needing to sell the stock and paying capital gains.

The Make Up of a Collar

A collar is very simply the combination of long stock, a long put and a short call. The idea is to protect possible losses to the downside by owning a put. However, in order to avoid paying for the put, we also sell a call. Though appreciating collars can be created by buying the stock and put and selling the call at the same time, collars are usually used to protect gains in a stock already owned. 

Figure 1: Generic Risk Graph for Collar Strategy

If we already have a profit in the underlying security, the risk graph above would be shifted higher so that a loss could not occur. Normally, we set up a collar to allow for a small loss and a small gain. The risk of the trade is not to the downside, but opportunity risk. This is because if the underlying security rises sharply, we lose the opportunity to make these profits on any move above the sold call strike price.

Collar ParametersWhen using a collar strategy, there are several parameters that we need to calculate. 

• Limited Risk = Initial shares price – put strike price + net debit (or – net credit).
• Limited Profit = Call strike price – initial shares price – net debit (or + net credit).
• Breakeven = Initial share price + (put premium – call premium) divided by the total number of shares

By changing the strikes used for the call and put, we change the above parameters, so it is important to view a risk graph to get an idea of the risk and reward of the trade. Let’s look at an example:

Bought 100 XYZ shares @ $52
XYZ shares currently @ $75
Buy 50 strike put @ 1.50
Sell 55 strike call @ 1.25

The profit in the stock before we created the collar was $2,300 (100 shares times $23 a share in gains). If we feel the stock is going to struggle in the next three months moving higher and even could see a substantially decline, we can add the collar.

The problem with a risk graph showing this type of trade is that it won’t show breakevens or risk because in reality, there is no possibility of a loss. However, it is helpful to look at the risk graph to see what sort of possible risk there is to current profits. If set up correctly, there will be very minimal losses and possibly a minor gain. (see risk graph below).

QQQQ Mock Trade

As is usually the case, we learn more from doing than just reading. Therefore, let’s set up a mock trade using the Nasdaq 100 Trust (QQQQ) to show how a collar works and how it can really benefit a trader that has gains in stock or indices.

Let’s assume that back in mid-July 2006 we bought 500 shares of the Qs at a price of $36.03. Now, at the end of trading on January 25, 2007, the Qs are priced at $43.73. At this point, we have a gain of $7.70 per share for a total profit of $3, 850. Though we think the Qs will perform well later in the year, we expect some profit taking and would like to protect these gains and this brings us to a collar.

Bought 500 shares QQQQ @ 36.03
QQQQ @ 43.73
Current Profit = $3,850 (43.73 – 36.03) x 500
Buy 5 March 43 puts @ 0.75
Sell 5 March 45 calls @ 0.65
Total debit = $50 (0.75 – 0.65) x 500
Max profit = $4,435
Min. profit = $3,435

Figure 2: Risk Graph of Mock Collar Trade on Qs

Conclusion

What we have created is a trade that will not allow us to lose more than $415 of our current profits. At the same time, we can make an extra $635 in profits if the Qs close at or above 45 at March expiration. Of course, any move above 45 we miss out on due to owning a short 45 call.

Over the next few months, we will track this trade to show how it has worked. We will also delve in deeper to the math and ins and outs of the collar. Please ask any questions you have on my forum so that I can make sure to cover them in future articles.  


Jody OsborneSenior Writer & Options Strategist
Optionetics.com ~ Your Options Education SiteVisit Jody''s Forum