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A Little Tight Around The Collar\?

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Does it feel like your collar is squeezing your throat a little bit harder these days? Are you seeing open long positions bleeding away? Are you getting that sinking feeling that my net worth has evaporated? If so, then you're not alone. The carnage is everywhere. I keep reading about new layoffs everyday, companies filing for bankruptcy, retirees thinking about coming out of retirement, all because of the stock market.

If you want to play the options market, it's apparent now more than ever that you must take control of the "limited risk" nature of options. It's true that when you buy options, your risk is limited, but that limited risk can take a big chunk out of your capital. Yeah, I can buy a LEAP call for 2003 and wait it out. I have two years to be correct. Well, look at all those LEAP calls on CSCO, EMC, SUNW, ORCL, JNPR, CIEN, etc, etc. They have all been sliced by about 75% or more of their original value and the outlook doesn't look so good for at least a few more quarters. It's limited alright, but by now those positions are probably only worth $2 each. I know some of mine are.

So we have to take control of the situation and sell out the losers, (as painful as it may be) if you haven't already and work on the next strategy. It's hard to let go of a stock that you've felt will serve you well in the long run. It may have been good to you in the past, so you don't want to let go. Well, that's your decision, but do you think SUNW, CSCO, INTC care about how much money has been drained from your portfolio? Don't feel bad about selling stock. You'll not only make you wallet feel better, but also your psyche. Once you have the losers out of the way, you can think much more clearly. If you want to get back into these stocks in the future, then no problem. Buy them back when things look brighter.

I'd like to discuss an option strategy that corresponds to the title of this article. It's called a "collar." This is a great very low-risk, or no-risk strategy to use with LEAP options. It's good for those long-term positions that you originally wanted to let sit in your account and not have to worry about. This is truly one of those strategies.

A collar is constructed by buying the underlying stock, buying an ATM LEAP put and selling an OTM LEAP call. The put and call should be of the same expiration LEAP month. Because of the nature of long-term options, the calls will usually be priced higher than their equivalent puts. For this reason, the OTM calls can be used to totally offset the purchase price of the put and allow for some upside appreciation.

Let's look at some examples. IBM is currently trading at $92.50. The Jan 2003 $90 put and the Jan 2003 $110 call are both trading for about $16.40. This means we can buy 100 shares of IBM at $92.50, and buy the put and sell the call for even money. Our risk/reward is easy to calculate. Since the options were done at zero cost, our upside is limited to the strike price of the call which is at $110. So if IBM were at $110 or higher at Jan 2003 expiration, we would make $1750 per spread. At $110 or higher, the puts would expire worthless and the calls will get called away. But either way, we make the difference on our long stock:

$110 - $92.50 = $17.50 x $100 = $1750

Our downside is very limited. If IBM tanked to $50, our calls would expire worthless but we would exercise our $90 puts which would almost entirely offset the loss on our long stock. Since we bought IBM at $92.50 and exercised our put at $90, the most we would lose is $250. This is truly a limited risk, long-term strategy that is bullish in nature. We'll make money if IBM heads higher like we hoped and our loss is very minimal if IBM falls.

This isn't the only way to construct a collar. You can vary the strike prices around and you can vary the position size of either the calls or puts. In terms of shifting the strike prices, you can substitute the IBM $110 call with the $100 call. This will give you a net credit when initiating the spread. The $100 call will trade at $20 and the $90 put still at $16.40, giving us an initial credit of $3.60. Since we have lowered the strike of the call, our upside is capped at the $100 strike which could theoretically give us a maximum profit of:

$7.50 ($100 - $92.50) + $3.60 (initial credit) = $11.10 upside profit

Our downside would even show a profit too now! If IBM went belly up and became a worthless company, we still could exercise our $90 put against our long IBM from $92.50. This would result in the same -$2.50 loss as before, but now we have our credit of $3.60 to cushion that loss too. So our downside is actually a positive $1.10 per spread. This is truly a "can't lose" position. We make money on the upside and the downside. How's that for a strategy? Our only drawbacks are the commission costs and the limited upside potential. But there's nothing that says you can't buy back the short call at anytime if you feel IBM is truly headed higher. Who wished they had executed some collars last spring right before everything tanked? I'll be the first to raise my hand.

Here's a variation of the collar that I learned from a friend recently. Instead of doing the OTM/ATM version for the calls and puts, you can do them both ATM and use a different amount of options. We could buy 300 shares of IBM at $92.50, buy 3 $90 puts at $16.40 (total $49.20), and sell only 2 $90 calls for $24.60 (total $49.20). What we have done here is cut back on the amount of calls which would give us unlimited potential on the upside because we only covered 200 of our 300 IBM shares with the short calls. The prices of the options offset each other like before, so there's no cost for doing the options. Once again, our downside is limited to the -$250 loss, but we've gained the chance of unlimited upside potential.

It truly is amazing what kind of strategies you can put together with options. There's one for every kind of scenario, you just have to create it. Take a look at the collar as it is a very powerful strategy. As we have all learned the hard way over the last year, it's good to protect your upside and your downside.

Good luck.

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