Option Investor
Educational Article

The "Collar" of Money

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Weve devoted a chunk of time discussing covered calls. There are good points and bad points to the strategy. My biggest problem with covered calls is that youre exposed for the entire value of your stock down to zero. Thats a lot of risk too much unless you know how to control it.

Some people are obsessed, which is hardly breaking news. Controlling ones obsessions is easier said than done. But they say that, if you can admit the problem, its half the battle.

People say no to drugs. They may say no to alcohol. They may even say no to Jessica Alba (I cant imagine why), but many cant bring themselves to say no to owning stock in this market a potentially fatal character flaw that may result in the untimely death of your portfolio. Its a disease that not even a 12-step program will help. Why? Because youll likely be broke before you get to step 6.

If You Absolutely Must

Lets proceed to that world where the path of least resistance and the path to profits are one in the same. Were going to try and help those lost souls who have no control and simply MUST own stocks in this (or any) market environment.

In one sense, I applaud the utopian glass is one-third full optimistic approach to managing money. Optimism is a good quality. But it has absolutely nothing to do with reality. Dear optimistic directional traders: Be sure to let me know what it's like to stand in line for government cheese.

Maintaining A Short Leash

Maybe I can help, but to do so I'll have to put you on a short leash. At the end of that leash is a "collar." In essence, what we're going to do is to put a collar on your stocks that won't let them stray too far.

For example: The market has been tanking. A few months ago you had a vision of a bottom and it wasnt your wifes. You bought 1000 shares of IBM which is (at this writing) trading at $77.81. Is there a way to be sure of market direction? Of course not -- unless youre hearing little voices or had a recent consultation with Miss Cleo. But thats a whole other set of issues.

The fact is, we rarely have a clue where the market is going. One thing is certain. We don't want to experience adverse market movement without the proper protection. That's what the "collar" is for.

The Example

With IBM at $77.81, if you had sold the IBM July $80 call (a covered call), you could have taken in about $.80 ($800 for 10 contracts). Now, where is this $800 going to do you the most good? It's a matter of priorities. You could:
1) Fly to Las Vegas, catch a show, dine at the $6.95 buffet and gamble the rest away.
2) Apply it to your wide-screen TV or liposuction fund.
3) Take your wife to the local spa for a Botox treatment and a full day of pampering. Your wife will love you for it, but it will be forgotten in two weeks, and the wrinkles (hers, not yours) will probably reappear anyway. OR, you could have
4) Purchase some insurance on your $59,000 investment.

The astute options trader will resist the temptation of choices 1-3. He will use the $800 to buy 10 of the July $75.00 puts for about $.70 ($700). This would have, in effect, protect you if IBM moves down. Keep in mind that IBM may be only an earnings warning or an accounting irregularity away from $65. The $75 put would have protected you on any IBM transgression below $75 (all the way down to zero) through July option expiration.

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Now, lets look for a way to help finance our protection. Look at the possibility of selling an out of the money call against your stock shares. The sale of a call (covered by the shares) will usually pay for all, or most of, the insurance put. Look at the chart below. The July $80 call is selling for $.85. In this case youd actually have an extra $.20 ($200). The $2.81 difference between the $75 put strike price and the $77.81 price of the stock is viewed as the deductible.

If You Dont Sell The Call

The cost of this insurance for the July cycle is roughly $.65 per share per month IF you dont sell the call. If you truly believe IBM is headed up, the added $.65 cost for your insurance is pretty insignificant. The longer-term investor can lower his cost per month buy purchasing puts further out. You could even buy an option out to January 2007 for about $2.65. That would bring your cost of insurance to about $.38/month. If you dont sell the call to finance your insurance, youre not putting a cap on your profit potential. IBM can go to the sky without any encumbrances. If IBM moves up significantly, you can sell the current protective put and buy another protective put at a higher level locking in a large percentage of your profits and, once again, have the necessary protection.

The collar limits what could be a catastrophic loss to a tolerable deductible and allows for IBM to appreciate by $2.22 before you're at risk of losing the stock through assignment. You can repeat the process month after month until your stock gets called away which is a good thing! It means you made money, which, if Im not mistaken, is the object of this exercise.

You Gotta Know When To Fold Em
Some people do, however, become attached to their stocks. They carry a grudge. Its simply not healthy emotionally or financially. They think that if they lose money on a particular stock, they have to make it up in the same stock. When you buy a stock, where does it say till death do you part? Remember, its only a stock. Dont become emotionally involved. If it goes, it goes. Add up your profits, smile and get on with your life. If it goes down, take your loss like a man and move on with your life.

There are no monogamy laws or divorce penalties in the stock market. You can play the field. There are thousands of other stocks out there. Just make sure you use protection. Sound vaguely familiar?

By the same token, if youre bearish, you can construct the same scenario by shorting a stock, selling an out-of-the-money put and buying an out-of-the-money call to protect your short stock position.

In most cases, youre allowed to sell covered calls in your IRA. Most brokerage firms will allow you to establish collar positions by purchasing the protective put in your IRA. If your broker doesnt permit this, you have the WRONG broker.

Having Your Cake And . . .

In summation, you can have your cake and eat it too. The collar enables you to own a stock, have room for profit, possibly pocket a few dollars, and be protected on the downside. Youll find that having your cake and eating it beats the hell out of the prospects of digesting that government cheese.

Were not going to cure the stock ownership disease with the collar, but we can bandage the wound and stop the bleeding at least temporarily. However, dont be surprised if, before long, the obsessive-compulsive stock-buyer is back out there, unprotected, still trying to catch those falling knives with bare hands.

Go figure.

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Who Is This Guy? --
Mike Parnos has "been there and done that" - plenty! Known as the MasterTater and "Options Therapist," Mike has been writing the profitable and popular Couch Potato Trader column (for OptionInvestor.com) for almost five years. Hes been trading, consulting and teaching option strategies for over 12 years. Both individually, and through his writings, Mike specializes in teaching conservative and non-directional option strategies while providing therapeutic guidance to thousands of individuals, brokers and institutional traders.

For serious traders, Mike offers a comprehensive two-day seminar covering many fascinating and profitable non-directional strategies. Feel free to send questions and/or comments to Contact Support Parnos1@comcast.net.

Over the years, he has learned from his mistakes, and the mistakes of others, and he's here to share his wisdom with you. "Trading is as much psychological as it is skill," says Mike. "Keep an open mind. You never know what might find its way in there."
 

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