If you're going skating on thin ice, you better be dressed warmly. Investors who are venturing back into equities this winter might want to take special care with their collars.
What are collars? Traditionally, collars are options positions that trade limited upside potential for partial downside protection.
An example might be in order. Imagine that traders decided on Friday, November 21, that it was time to venture out onto thin ice by buying 100 shares of Merck & Co (MRK) for $24.40. Those traders might have hoped that it was time for markets to bounce but might have been afraid that their hopes would be dashed. As of Friday, November 28, 2008, they would have been okay, with MRK trading at $26.22 at about 10:25 am ET, but that's hindsight. Traders who have weathered the ups and downs of recent market moves and who might have considered purchasing MRK on November 21 knew how quickly an upside move could be reversed.
What could traders who had bought MRK stock a week earlier have done to protect their position? They could collar the stock by selling a call against their shares and using the money collected to buy a put.
For the purposes of this article, calculations for buy and sell prices for options will assume a approximate 30/70 split between the bid/ask spread when possible, with options sellers collecting 30 percent of that spread and options buyers paying 70 percent of that spread. This proves more conservative that an assumption that both buyers and sellers could get prices at the midpoint, especially in a volatile market.
On Friday, November 21, investors who had bought 100 shares of MRK at $24.40 could then sell a JAN 27.50 call for $1.65 then use the proceeds to partially offset the purchase of a JAN 22.50 put for $2.25. The total debit would be $60 ($0.60 x 100 multiplier) plus commissions. The total cost for commissions for stock purchase plus commissions and costs for the collar would be $104.85 at my broker.
Therefore, the total costs for the collared 100 shares of MRK, including the stock purchase, would be $2544.85. What has been accomplished if the MRK shares rise or if they fall? A profit/loss chart shows how the trade would unfold at January expiration.
Profit/Loss Chart for 100 Shares of MRK with Collar:
After MRK rises above $25.45, the trade moves above the breakeven level. The maximum profit is $205.15 (the 27.50 strike of the sold call minus the cost and commissions of the collar and the commission for the stock purchase). The chart is misleading since it does not appear to take into effect the commission costs so that the maximum profit appears higher, but the flat line after breakeven indicates that profit flattens. Upside potential is limited in a collared stock, at least for the duration of the option expiration cycle in which the stock is collared. No matter how high above $27.50 MRK stock might climb, that profit is the maximum that can be collected.
If MRK is below $25.45 at expiration, the cost of the stock purchase plus the collar, the trade loses, but no matter now much further MRK might drop, the losses are limited to $294.85, the loss that would occur if MRK is at or below the 22.50 strike of the long put. If MRK is below $22.50, the long put protection kicks in.
Unfortunately, the current climate has skewed options prices a bit. In typical market conditions, calls are higher priced relative to puts than they are now, and traders could find low-or-no-cost collars with closer put protection. Also, traders who have lower commissions or who were purchasing more than 100 shares of stock and more than 1 contract each of the collar's options trades would not find commissions taking up so much of the potential protection offered, either. It would always be possible to construct a no-cost collar by buying a further out-of-the-money put. However, even with the slight difficulties posed in this market environment, traders who expected a modest rise in MRK but who wanted some downside protection, too, might find a collar attractive.
Collars should be discussed with a knowledgeable broker before they're initiated. For example, if you've held a stock for ten years and it's above your purchase price and you expect a big capital gain hit next year, you might not want to risk the stock being called away in January and having to take capital gains on that stock. Other unforeseen consequences could occur. This article is not recommending either a MRK stock purchase or a collar on the purchase if you're considering it, but instead uses MRK only for the purposes of showing how a collar works.
This type of collar is a traditional collar. Just as people wear different styles of collars, collars around stock can vary, too, according to the needs of the investor. Those other types of collars will be discussed in a Trader's Corner article, but they include collars that would allow a trader to capitalize on a decline in the held stock rather than just offer protection (hint: more long puts than sold calls) or allow a trader to lock in gains in a stock without selling it yet if a sell would not be advantageous for tax reasons (ATM collar). The trader who expects a huge gain in a stock and who wants to capture that gain but still wants some downside protection can perhaps find a collar style that fits that trade, too. If you want to know more, you'll find webinars about collars on the CBOE and also OCC, the Options Clearing House. I recommend both sites.