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Another Downside Strategy

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Another Downside Strategy?
By Lee Lowell

This seems to be all we can talk about these days. I'm tired of all my holdings going down in price. There's only so much downside protection covered calls can give you, and I don't like buying puts all that much because I'm more of a premium-seller kind of trader. So what else can we do in this bearish environment while keeping our long-term bullish opinion? We can actually combine these two trades to form a strategy called the "collar."

A collar is a strategy that is just like a covered call trade but with a twist. The collar is a combination of long stock, long an at-the-money put and short an out-of-the-money call. It is ideal to use this strategy on a stock that is somewhat volatile so the discrepancy between the put and call premiums is more pronounced. You want to use LEAP options so you have enough time for your bullish bias to work out and because the pricing of the options are more favorable the more time you have. So you buy the ATM put to give you the downside protection and sell the OTM call to pay for that protection. The call premium should be more than the put premium so that you can establish the spread for a credit. This strategy gives you complete downside protection for zero debit or a credit into your account, along with the chance for good upside potential.

With a regular covered call approach, your downside is protected only to the extent that the short-call premium gives you. Plus, your upside is capped at the short-call strike. With the collar, your upside profits are also capped, but you are protected all the way down to zero. Plus, you've received a credit for your effort. Sounds like a no brainer to me. What's the catch? There really isn't one except that your profits may be capped and you may have to wait awhile to see the rewards. But we are here for the long-term, so that doesn't bother me.

Let's take a look at an example with real prices. You want to get in on the hot fiber optic sector and decided to take your chances on Corning, Inc. (GLW). This is a volatile stock, to say the least--just what we want. As of this writing, GLW is trading for about $297/share. You want to hop on board but you've seen the destruction that some of these high fliers have done in the recent past. To insulate yourself for one of those nasty downdrafts, let's put on a collar. We'll buy 100 shares of GLW at $297, we'll buy 1 Jan 2003 $300 put for $83, and we'll sell 1 Jan 2003 $400 call for $85. This gives us an initial option credit of $2, theoretically bringing our 100 share purchase price of GLW down to $295.

So where do we stand? We've got 100 shares of GLW with a cost basis of $295, we're long a Jan 2003 $300 put, and short a Jan 2003 $400 call. What does the risk/reward look like? In a worst case scenario, if GLW goes belly up and falls to zero, we'll walk away with $500 in our pocket. This is because we get to exercise the $300 put which means we get to sell GLW for $300/per share. Since we bought GLW for $297, plus our initial 2 point credit, that's 5 points ($500) profit no matter what (excluding commissions). What about the upside? That's even better. We have a 100 point leeway. We won't start giving up profits until we hit $400 per share. So come expiration day in Jan 2003, if GLW ends up at $400, we'll make 105 points x 100 shares = +$10,500. Not too bad. And that's only working with the minimum amount of contracts. Do that with 1000 shares and 10 option contracts and see what you get. So at the extremes, we'll either end up with $500 if GLW goes broke, or we'll make 10K if GLW goes up to $400/sh. Looks pretty good. I think anyone who gets to sell a covered call 100 points OTM, buy an ATM put for total downside protection, and gets to take in a credit for the trade, is doing very well.

If it's still confusing, let's break it down using total dollars to help clarify. If GLW goes bankrupt, we'll lose $29,700 on the long stock. We'll make $21,700 on the put ($300 strike - $83 premium = $217 x 100 = $21,700), and we'll make $8500 on the short call expiring worthless. $21,700 + $8500 = $30,200 - $29,700 = $500 total profit. Or put another way, just take the $300 put and subtract the cost basis of $295 for GLW and you get $5 points x 100 = $500. If GLW goes up to $400/sh. by expiration, we'll make 103 points on our 100 shares for +$10,300 ($400 - $297), plus the $200 initial credit from the options to give us a total of +$10,500.

The collar is a great way to protect yourself on the downside and to give you some room for profit on the upside. The GLW trade is really great because you have over 100 points of upside potential before having to give up profits and you're protected all the way down. This type of strategy can work for almost any stock. But you must look at long-term options and stocks that are a little more volatile. Of course, you can always adjust the collar in terms of strikes, expiration dates, etc. If you are really bullish you can actually reduce the amount of calls you use (if you are doing multiple contracts). Let's say you buy 1000 shares of stock and 10 put contracts. You can adjust the call strike and sell only 8 calls against the puts. As long as you use a low enough call strike whose premium will still outweigh the put price, you can still do the collar for a credit. So if your stock starts to rise, you will make more money sooner than later because you only have 8 short calls instead of 10 short calls. Theoretically, this gives you unlimited upside potential now instead of being capped. Give it a try. Good luck.

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