As part of my series on long spreads, I mentioned in passing how long call spreads are essentially synthetic collars. Wonderful -- but what's a collar? Several of you have asked that very sensible question in the meantime, so I thought I'd do a post explaining that position on its own. If you've had a nice run-up in a stock position, collars can help you protect those profits against a downturn (and maybe earn a little extra income at the same time). What's a collar?
A collar includes three parts: a stock position, a put that you buy and a call that you sell. Generally you'll buy the put at a strike slightly lower than the current stock price -- that's your downside protection. You sell the call at a strike slightly higher than the current market price. Between those two high and low strike prices sits your stock position, "collared" on both sides.
Let's make this concrete straightaway with an example:
100 shares of IBM, bought at 96
IBM now trading at 116
Buy an October 115 put @ -2.85
Sell an October 120 call @ +1.55
Net debit -1.30
Here's the set of conditions you might be contemplating that leads you to consider a collar. You're sitting on top of 20 points of profit on your long IBM position. You may still think IBM could go higher, but in the short term you're nervous. The last thing you want is to lose this tidy profit due to some short-term bumps. You're nervous enough that you're willing to forgo some future upside -- as you see it, you've had a great run already, so it wouldn't be a shame to sell the stock if you had to now.
A collar at this stage might address all your issues in one strategy:
Protection. Buying the put lets you sell your IBM at 115, leaving you with at least 19 points of profit on the long stock. Underwriting that protection. Selling the call offsets the cost of buying the put protection. It also caps your upside: after all, if the stock rises above 120, the call buyer will exercise, and you'll most likely have the stock called away from you. Still, at 120 you've secured 24 points of profit on your long stock, so you're not too unhappy about that.Well, those are your profit points if you're talking just about the stock alone. As part of a collar if the position is put on with the stock at 116, at that point the following max risk, profit and breakeven points apply:
Max risk: 116 - 115 - 1.30 = -2.30
Max profit: 120 - 116 - 1.30 = 2.70
Breakeven: 116 + 1.30 = 117.30
Now you're looking at a fuller picture. Essentially you're rooting that the stock move higher than 117.30. If it moves all the way to 120 or higher, your maximum profit for the collar will be 2.70 (plus the 24 points of profit for the long stock). If things don't go your way, the worst-case scenario sees you selling your IBM for 115, having spent 1.30 to protect that long-stock profit.
After the collar is established, how do changes in IV or time to expiration affect your collar? Not much, as it turns out. Increases in IV will make your sold call increase in value, but your bought put will also increase in value. Similarly, time is eating away at your put but working to your benefit on the call, so it's basically a wash.
Variations on a theme
The collar in this example was established as a net debit, but it's also possible to tweak things so that your collar is "net-zero cost" or a net credit. To get a net credit, you'd be selling the call for more than the price of buying the put -- but the strike on the call will always be higher than that of the put.
Some investors establish collars as a single trade: for every 100 shares of stock, they'll sell 1 OTM call and buy 1 OTM put. That's fine, as long as you realize that you're limiting both your downside risk and your profit potential to the confines of the collar.
Well, glad we could get that out of the way. Next week I'm kicking off a new series on another much-discussed question: what should you do if you're exercised against early? Keep an eye out for that one next Monday.
Regards,
Brian (OG)
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While implied volatility represents the consensus of the marketplace as to the future level of stock price volatility or probability of reaching a specific price point there is no guarantee that this forecast will be correct.
Any strategies discussed or securities mentioned, are strictly for illustrative and educational purposes only and are not to be construed as an endorsement, recommendation, or solicitation to buy or sell securities.