What Are Options | The Collar | Protecting Unrealized Gains by Establishing a Collar
What Are Options | Establishing a Collar
Every so often there are securities in an investor’s portfolio that have substantially appreciated in price. In fact, many investors that purchased equities during the market crash of 2008-2009, have generated a considerable unrealized profit, as the market has roared back as the US economy emerges out of the worst recession since the Great Depression. Often, investors that have accumulated unrealized profits wish to protect gains, but are hesitant to sell a position because they would like to participate in any additional price appreciation. In this scenario, investors should consider establishing a collar.
A collar is an options trading strategy used to protect unrealized profits from price decline via the purchase of a protective put contract. For each collar established the investor must own 100 shares of the underlying company. A collar is implemented via the purchase of a protective put contract and the simultaneous sale of a covered call. Typically, both the call and put are “out of the money”. This means that that current stock price is higher than the strike price of the put, but lower than the strike price of the call. The purchase of the put acts as a “hedge” by providing protection from a price decrease, because if the underlying stock price were to decline dramatically, the investor can exercise his right to sell at the strike price. In addition, the sale of the covered call allows participation in further upside to the strike price.
First, let’s examine the basics for clarity.
A put option is a contract that gives the buyer the legal right to sell shares of the underlying stock at the strike price, before the expiration date. For this right, the buyer pays the seller a premium, which the seller collects and keeps. The buyer is never obligated to exercise this right to sell and can allow the option to reach the expiration date, at which point it becomes worthless. Typically, one put option is equivalent to 100 shares of the underlying company. By purchasing a protective put the investor retains all benefits of stock ownership such as collecting dividends and preserving voting rights, until the stock is sold. The put serves to limit downside because if the underlying stock price falls, the put price will increase, thus limiting the loss. Additionally, the if the owner of the put has the right to purchase the stock at the strike price regardless of how low the stock price falls.
For more information on using put options to acquire discounted stock check out my hub "Options Investing: Writing Puts to Generate Additional Income or Acquire Discounted Stock"
A call option is a contract that gives the buyer the legal right, but not the obligation, to buy shares of the underlying stock at the strike price, before the expiration date. For this right, the buyer pays the seller a premium. The buyer is never obligated to exercise this right and can allow the option to reach the expiration date, at which point, it becomes worthless. Conversely, selling or “writing” calls creates and obligation for the seller to deliver shares of the underlying company at the strike price upon assignment. Typically, one call option is equivalent to 100 shares of the underlying company.
You can find more information about call options at these posts:
Now let’s look at an online option trading example.
In March 2009, during the pinnacle of the financial crisis, Kyle purchased 500 shares of American International Group, Inc (AIG) at $1.50/share, which cost him $750. A gamble at the time, but Kyle was following the advice of Warren Buffet to “buy when others are fearful, and sell when others are greedy”. Today, AIG is trading for $51.20/share. Therefore, Kyle’s account balance has increased from $750 to $25,600, a very substantial gain! Kyle is concerned about protecting his massive unrealized gain, but is also worried that if he sells the stock he might miss out on any further price appreciation. He consults his financial advisor and decides to establish a collar using options. For downside protection, Kyle purchases 5 contracts of the 48 May 2011 put option for $4.55 which cost him $2,275 (4.55X5X100). Simultaneously, Kyle sells 5 contracts of the 55 May 2011 for $4.20 for a total of $2,100 (4.2X5X100). Therefore, the total debit for Kyle to establish the collar is $175.
Are collars helpful to your portfolio?
First, on the third Friday of May 2011 (expiration day for options is the Saturday following the third Friday of the month, but brokers and markets are closed, so the last trading day is Friday), the market price for AIG might be $38/share. This is a substantial decrease since December when Kyle set up a collar using options. At this point Kyle can exercise his 5 put contracts and sell 500 shares of AIG at the strike price of $48/share. Kyle’s net profit is $23,075 ((500X48) = 24,000-750-175)). This means that by implementing the collar, Kyle was able to sell his AIG stake for $4,825 ((24,000-19,000)-175)) more than the current market price. Therefore, Kyle was able to hold onto his position in AIG, yet still protect most of his unrealized profit from December.
Second, on the third Friday of May 2011, the market price of AIG might be $60/share. At this point, Kyle will most likely be assigned to sell 500 shares of AIG at $55/share. This leaves him with a net profit of $26,575 ((500X55)-750-175)). In this case, the covered call limited his ability for further gains past the 55 strike price. However, after such a large run up, Kyle is happy to take his profit and pay down his mortgage.
Thirdly, on the third Friday of May 2011, the market price of AIG might be $50/share. Both positions established by the collar are “out of the money” and expire worthless. In this case, Kyle need not take any action. He is able to retain is 500 shares of AIG, but loses $175 that it cost to establish the collar. The collar protected Kyle’s investment from any major decline in price from December to May, for a relatively small cost. If Kyle is still concerned about any upcoming market catastrophes he can establish a second collar.
Options Action Examples
- Options Action
Airtime: Fri. Sept. 4 2009 | 7:43 PM ET Skip to the 1:20 mark to see the section on collars.
- Options Action: Apple -
Options Action expert Dan shows you how to implement a collar on the technology stock Apple.
- Options Action: Alcoa
Mike Khouw of Cantor Fitzgerald explains how establish a collar on Alcoa after a 20% gain.
In conclusion, using online option trading to establish a collar can be an effective way to protect gains that investors have accrued since the beginning of the economic recovery. If executed correctly, the collar can be established for “zero cost” or possibly for a small credit. However, the investor must be willing to sell his shares at the strike price of the call, should the price continue to rise.
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For a more visual description of a collar, watch the video on the right.
- Options Basics: Introduction
Investopedia has a section on options basics. It is a useful resource for those that wish to learn about options.
- The Options Industry Council - Giving You the Power of Options
OIC is by far the best and most comprehensive online options learning tool I have found. The site includes online classes and tutorials on options basics, equity options, index options, and LEAPS. If your new to options start here!