Larry McMillan discusses Partial Collars and using VIX options as alternatives.
Hedging - the bane of many investors existence in times like this. Why? Because if you didn't hedge before the current crisis, many feel it is either too costly or too late to do it now. This is the situation facing many people today - both from a "macro" and a "micro" viewpoint (with "macro" protection, one buys index hedges against his portfolio, while with "micro" protection, one sets up hedges against each individual stock in his portfolio, using equity options.) In the following post I will provide alternatives that may be appealing to some of you dealing with this dilemma. If you are not familiar with this tactic, please take a few moments to review The Basics of the Collar Strategy. You may also find it helpful to read about collars in the online version of The Options Playbook, located in TradeKing's Education Center.
THE PLAY - Collar
ALL-STAR COMMENTARY
At the end of the post Net-Credit Collar, I showed how to setup a macro collar with $SPX options. The purpose was to hedge a portfolio that performed more or less in line with the broader market (e.g. like the $SPX)
$SPX: 1517
Buy Dec ('09) 1450 put: 107.60
Sell Dec ('09) 1700 call: 118.80
However, I did not explain what the capital requirements would be or how one would meet these requirements. From a purely margin standpoint, this is a long put and a naked call. The long put must be paid for in full, just as any other long option purchase. However, the naked call must be margined.
For naked calls, TradeKing requires minimum margin of the GREATER of:
a) 25% of the index price, plus the call premium, less any out-of-the-money amount OR
b) 10% of the index price, plus the call premium.
So, initially, the Dec 1700 call was trading at 119, and $SPX is at 1517. The requirement would be:
= (25% x 1517) + 118.80 (call premium) - 183 (out-of-the-money amount)
= 379.25 + 118.80 - 183
= 315.05 or $31,505 per naked call sold
This is greater than 10% of the $SPX price ($15,170), so it is the initial requirement. Hence you would need to have that much excess equity in your stocks in order to be able to sell this call.
Generally, this can be done by using the equity of your stock portfolio - in fact, it is almost always done that way. In order for one to meet the margin obligation of the naked call, one may have to hold the long stock in the portfolio at 100% (the stock would not be held on margin.) Furthermore, if the market should rise, the requirement would grow. Of course, so should the equity in your account which may help you meet this requirement. Keep in mind that the rate of the increase in the requirement versus the rate of the increase in your shares may not be equal. Your call requirement could outpace your equity growth, so you may need to maintain excess capital to meet future margin requirements caused by the naked calls.
Variations on the Collar
Some traders may prefer to vary the months in the collar. Others may use a slightly lower striking price on the call to collect more premium. Yet another choice is to sell fewer calls than the number of shares, so that there is still some upside potential in the position. This last one is called a partial collar.
Let's work through an example of. Suppose XYZ is trading at 30, and you want to establish a collar. At this point in time, the longest-term options are the Jan 2010 LEAPS, so you'll use those:
Example: full collar
Long 100 XYZ stock (currently trading at 30)
Buy 1 XYZ Jan (‘10) 25 put for $2.00 (per contract per share)
Sell 1 XYZ Jan (‘10) 40 call at $1.80 (per contract per share)
The implied volatility of the put is a bit higher than that of a call, so a no-cost collar can't be established. ($2.00 debit less $1.80 credit.) Now, you might say, "What's 20 cents?" But if this is a 10,000 share position (or any large position), that cost adds up, plus commissions.
A partial collar can also be considered. This is a no-cost strategy, so it provides just as much downside protection. It might limit the upside a bit more, but not necessarily so.
Let's assume that this trader has 10,000 shares of XYZ stock (this strategy works for smaller blocks of stock, too). Furthermore, suppose the Jan 35 call can be sold at a price of 3.00.
Example of a partial collar:
Long 10,000 XYZ stock (currently trading at 30)
Buy 100 XYZ Jan (‘10) 25 puts for $2.00 (per contract per share) = $20,000
Sell 67 XYZ Jan (‘10) 35 calls at $3.00 (per contract per share) = $20,100
There is no cost for the hedge (the call sale premium is slightly larger than the put cost). The "problem," if there is one, is that the stock is somewhat limited above 35, whereas the "full collar" in my earlier example doesn't limit the stock until it reaches 40.
However, in the "partial collar" strategy, one has the ability to roll the calls up if that becomes necessary. The question then becomes, can 67 XYZ Jan (‘10) 35 calls be rolled up to 100 Jan 40 calls for a credit, if the stock rises to 35 or higher? It turns out the answer is a qualified "yes." After about six months have passed, if the stock rises to 38 or slightly higher, the ratio of the Jan (‘10) 35 call price to the Jan (‘10) 40 call price is about 1.50. So yes, 67 short Jan (‘10) 35 calls could be bought back and rolled up to sell 100 Jan (‘10) 40 calls for about even money.
Moreover, if some strange upside event should occur (e.g., a hostile takeover), the "partial collar" has unlimited upside potential, so the investor could take advantage of that with at least part of his stock position (3,300). This is because we have only sold 67 calls instead of 100. In summary, traders looking to protect their stock positions should consider the "partial collar" strategy.?
Collaring $VIX Options
In modern portfolio management, there is an alternative to using $SPX options for "macro" protection, and that is to use $VIX options. $VIX rises when the market falls, so a proper hedge to a portfolio would be to buy $VIX call options or to buy $VIX futures.
$VIX options are a much more dynamic way to protect your portfolio, and it doesn't cost so much in the way of equity margin requirements, either. $VIX protection is dynamic, because no matter how far the market ($SPX) rises after you have purchased the $VIX calls as protection, they will always be ready to spring to life in a true market debacle.
For example, suppose $SPX was 1400 and $VIX was 20 when you established protection. Perhaps you bought $VIX calls with a striking price of 25. If $SPX rises, $VIX will fall, so if there is a big market rally - say $SPX rises to 1700 - $VIX will drop. However, if $SPX then crashes or suffers a meltdown, $VIX will still rally well beyond 25 and so your protection is still "working" for you.
Consider a similar example with $SPX puts. With $SPX at 1400, you might buy the $SPX puts with a striking price of 1300 as protection. If $SPX then rises to 1700, your protection is essentially worthless. You'd have to buy more at a higher striking price in order to be protected if $SPX should crash or suffer a meltdown from the 1700 level.
So buying $VIX calls is a reasonable way of protecting your portfolio from a broad market decline.
A $VIX collar could also be used, and it would take this form:
Buy (out-of-the-money) $VIX calls
Sell (out-of-the-money) $VIX puts
The sale of the puts won't likely bring in much money, so this probably isn't as advantageous as an $SPX collar or equity option collar might be. So, perhaps the best form of protection is merely to buy $VIX calls.
In Summary
The decision to set up a hedge to protect one's stock portfolio is never an easy one. When times are good and stocks are rising, investors are loathe to spend the money required to hedge their positions. When times are bad, and the market is dropping, the cost of hedging increases. However, that fact is usually understood by investors, who might not mind paying a little more for insurance once it is obvious that stocks are no longer rising, in general. However, another impediment to hedging usually surfaces at that time: an investor fears that he has waited too long, and thus doesn't want to buy insurance right at the bottom of the market's decline.
An investor faced with plummeting stocks in his portfolio might want to consider some form of hedging. But he might ask, "Is the decline almost over?" or "Isn't the market so oversold that it has to rally now?" In my opinion, once one has made the decision to hedge - presumably because he doesn't want to lose any more than a fixed amount in his stock position - he should not try to time the market in order to establish his hedge.
--Larry McMillan
"Option Strategist"
McMillan Analysis Corporation
All-Star Commentator
Larry's previous posts: Collars: If bearish, why not sell the stock? and Collars: Using Different Months
Click here for a list of previous TradeKing All-Star blogs.
Nicole Wachs contributed to this post.
Options involve risk and are not suitable for all investors.
Please read Characteristics and Risks of Standardized Options.
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 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.
Lawrence G. McMillan has a professional business relationship with TradeKing.
