Larry McMillan answers Condortrader's questions.
The following post is in response to another question on my first blog on collars (The Basics of the Collar Strategy). If you like, please continue the series with The Net-Credit Collar and Collars: Using Different Months. If you need more material before continuing, please see Play #8 in the online version of The Options Playbook, located in TradeKing's Education Center.
THE PLAY - Collar
ALL-STAR COMMENTARY
Question: In using a LEAPS collar you are establishing long term insurance for 2+ years. If one is truly that bearish on a position it wouldn't seem to make sense to just sell the position. My understanding of collars was that they are most typically used for front month options, maybe going out 2-6 months. Granted the LEAPS call will be able to sold much further out of the money for a higher price, but conversely the LEAPS put option will also be quite expensive even for an out of the money put. I don't quite understand the rationale for using LEAPS in a collar strategy, because if someone really lacks conviction in a stock for such a long time frame (2-3 years) it wouldn't seem to make sense to continue holding it. Just sell the stock. Is the intention to repurchase both of the options in the collar back before expiration, for example if the underlying moved sharply in one direction, or to hold them through expiration?
-- from Condortrader
Answer: Using long-term collars allows you to raise the protective level of the put as high as possible, while allowing for the most possible upside appreciation. In The Net-Credit Collars, I described an actual situation in CSCO stock where, with the stock at 130, a 3-year collar was constructed with the put strike at 130 and the call strike at 200. Thus, you have no risk, and you can make slightly more than 50% from the current price. I wouldn't say someone lacked conviction if he can make 50% on the stock in three years - with no risk.
Also, in many cases traders may have tax consequences if they were to merely sell the stock. The use of a collar keeps the long-term tax status of the stock intact (assuming it was already long-term when the collar was purchased).
Perhaps you would feel more comfortable using the "half" short-term strategy discussed in the previous blog Collars: Using Different Months for Calls and Puts (buy short-term puts and sell LEAPS calls).
As for your suggestion that collars are typically used for 2-6 months, I don't agree with that. Typically collars are no-cost collars when used by professional and institutional traders, and you can't get much upside out of a no-cost collar when you use such short-term options. The only way to get some upside room in that case would be to pay a debit for the collar. If you look at the cost (debit) of such collars and the protective ability they offer, I rarely see the merit in that strategy. In fact, if you are willing to accept the poor levels of opportunity vs. risk that short-term collars offer, I would contend that that is when you might want to sell the stock instead.
Perhaps looking at a theoretical example will make this clearer. Following is the example of a long-term LEAPS column, as shown in The Net-Credit Collar.
Underlying stock price: 100
No-Cost Collar using Jan 2010 LEAPS:
Buy Jan ('10) 90 put: 12.10
Sell Jan ('10) 120 call: 13.00
No-Cost Collar using Jan 2011 LEAPS
Buy Jan ('11) 90 put: 16.25
Sell Jan ('11) 130 call: 16.90
So with 2011 options we can get the call strike 30% higher than the current stock price and still establish the collar for a credit. With 2010 options, we could only get the call strike 20% higher. Let's look at the short-term alternative.
Using two-month options:
2-month put with strike 90: 2.35
2-month call with strike 110: 3.06
2-month call with strike 115: 1.98
So, to get a no-cost collar, you'd have to use the 110 strike and risk 10 points down to 90 - not a very attractive risk-reward situation. I suppose there is some scenario in which you could justify the short-term situation, but in most cases the collar should be used by investors, not traders - and by investors who are generally going to be in the stock for more than just the short term.
Finally, you ask what the exit strategy is. Usually, if the stock drops, the investor will remove the collar (at a profit) and decide if he wants to replace it with a collar using lower strikes than the original one had. On the upside, there isn't usually such a convenient exit if the underlying rises above the striking price of the written call. So, either the collar is held until expiration, or an exit strategy is employed in which the calls are bought back and perhaps a small portion of the stock is sold to finance the repurchase of those calls.
--Larry McMillan
President
McMillan Analysis Corporation
All-Star Commentator
Larry's previous posts: Collars: Using Different Months and The Net-Credit Collar
For a list of previous All-Star Trades, please click here.
Nicole Wachs contributed to this post.
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