Larry McMillan answers S90911's questions.

My next couple of blogs are in response to a couple of questions that have been asked by readers after the first two posts (The Basics of the Collar Strategy and The Net-Credit Collar). Before we get to that, I would like to briefly review the makeup of this trade. Remember the Collar (Play #8) is actually the combination of doing a Covered Call (Play #6) and a Protective Put (Play #7) on the same stock, at the same time, with all options using the same expiration month. If you need more information, please read the online version of The Options Playbook, located in TradeKing's Education Center. In the images below, each part of the collar trade is trade is separate. If they were combined together, with different time frames for the call and the put, the actual Profit & Loss graph would differ in appearance.

THE PLAYS:

COVERED CALL                                   PROTECTIVE PUT

ALL-STAR COMMENTARY

Question: Thanks for the interesting write-up. Is it usually the best strategy to buy/sell the same month? So, if the best strategy is usually to sell a LEAP call as far out as possible, do you also buy a LEAP put?

- from S90911

Answer: It is not mandatory that one use the same months for the purchased put and the written call in a collar.  There are circumstances where one might use a shorter-term call or put.  Most investors that utilize the collar strategy are happy to have the downside protection, but are reluctant about giving away the upside profit potential.    Let's see how those objectives figure into using different months for the put and call in the collar.

Long-Term LEAPS put vs. shorter-term call

One approach is to buy a LEAPS put, but to sell shorter-term out-of-the-money calls against it - probably using the same strikes as if LEAPS had been use for both.  (This strategy is sometimes named the Calendar Collar.) Typically, this would not be a zero-cost collar to begin with, because the shorter-term call won't have as much time value premium as a longer-term put.  However, if the stock remains relatively stable or rises during the time the position is in place, the calls can be rolled forward over time.  This might well produce a larger overall credit by the time this rolling is done throughout the life of the put.  That is, it might produce a larger credit than having established a no-cost collar with LEAPS calls to begin with.

The downside of this strategy is that if the stock moves too far, too fast, in either direction, the calls cannot effectively be rolled - and thus one would have better off with a LEAPS no-cost collar in the first place.

To see this, first consider what happens if the stock drops quickly.  The puts still protect the downside, but you won't be able to roll the calls at the same strike for much of a credit, if any.   Thus the initial debit you paid for the collar will remain your cost.

You might think that you could just roll the call down to a lower strike, but that would often be undesirable because you'd be lowering the cap on your potential upside too much.  A better strategy would probably be to remove the original collar (for a profit, since the stock has dropped sharply) and establish a new collar with lower strikes for both puts and calls.  So, at least there is an acceptable "out" when the stock drops sharply.

However, if the stock experiences a sudden rise in price, there is no such easy "out."  Suppose that, shortly after you establish the collar with a LEAPS put and short-term call, the stock rallies sharply or perhaps even gaps higher because of a takeover bid or other positive news.   In that case, you might be able to roll the call out to a later month for a small credit, but if the stock is too far above the call's strike, even that won't be feasible. 

Your only alternative (assuming you don't want the stock to be called away) would be to roll the call UP to a higher strike - adding more debit to the position (but also adding some upside potential).  The biggest problem with doing this, though, is that if the stock suddenly drops in price, that extra debit you added is now risk to the portfolio.  Of course, some adroit investors would figure that, with the stock moving sharply higher, the downside is not as much to be concerned about and would thus sell the protective LEAPS put, converting the position into an (in-the-money) covered call write.  That would help with the debit a bit, although the put would be so far out-of-the-money that selling it might not bring in much credit.

Shorter-term put vs. Long-term LEAPS call

The opposite case, if not using the same months in the collar, would be to buy a shorter-term put and sell a long-term LEAPS call.  This is usually done for a credit, perhaps a rather large one.  The main objective in doing this would be to try to minimize the expense for the downside protection.  Perhaps one feels that the downside is only in jeopardy for a short while and thus wants protection only during that period.

If the stock does indeed fall sharply, the protection can be removed or rolled down for a credit, as is the case with most forms of the collar.  However, if the stock remains rather stable or falls only slightly, and the put expires worthless, then one is faced with a decision as to whether or not to add more protection by buying another (short-term) put.  If he continually has to replace the put, the eventual cost of doing so will be more than if he had merely bought the LEAPS put in the first place.

So both forms of using differing months for the collar have advantages and disadvantages.  In short, though, when the call is short-term, it works best if the stock is relatively unchanged, so that successive calls can be rolled.  Conversely, when the put is short term, it works best if the stock is volatile, so that the put doesn't have to be rolled.

--Larry McMillan
President
McMillan Analysis Corporation
All-Star Commentator

Larry's previous posts: The Net-Credit Collar and The Basics of the Collar Strategy 

For a list of previous All-Star Trades, please click here.
Nicole Wachs contributed to this post.

Options involve risk and are not suitable for all investors.
Please read Characteristics and Risks of Standardized Options.

 

Any strategies discussed and examples using actual securities and price data are for educational and illustrative purposes only and do not imply a recommendation or solicitation to buy or sell a particular security or to engage in any particular investment strategy. In reading content in the Community, you may gain ideas about when, where, and how to invest your money. Although you may discover new ideas or rationale that may be compelling, you must ultimately decide whether or not to put your own money at risk. Consider the following when making an investment decision: your financial and tax situation, your risk profile, and transaction costs.

 

Larry McMillan has a professional business relationship with TradeKing.