Option Investor
Trader's Corner

An Old Fashion Made New

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When my daughters were in their early teens, a new fashion surfaced. Dresses, blouses and sometimes even sweatshirts were festooned with lacy collars. Those collars were wide enough to extend all the way to the edges of the thickly padded shoulders that were also in fashion. I couldn't help but think that their class pictures were going to end up looking as ridiculous as mine from the sixties.

Collars have their places, however, and they may be coming into fashion again: in the stock market, not on shoulders.

Imagine that by Monday, July 30, 2007, you had decided that the sell off from the previous week had been overdone, especially in the financials. You thought you might buy 1000 shares of Merrill Lynch stock, then at $76.12.

Annotated Daily Chart of MER on the Afternoon of 7/30:

You intend this as an intermediate-term buy to be held for several weeks, perhaps, not a long-term investment, but still you're not quite certain about your decision. You don't buy MER just yet. News from overseas shows that the implosion in the U.S. mortgage market is beginning to impact other banks. Britain's HSBC reported just that morning that it was going to increase its reserves because of the impact of the credit crunch. You want some protection.

Selling a covered call provides some, you know. By the time you've pulled up an options chain, MER has already risen a penny, so your purchase price has now risen to $76.13. These options prices were found at Brokersxpress when MER was at $76.13 that afternoon.

Near-the-Money Call Prices with MER at 76.13 @ 1:09 pm on 7/30:

You believe that MER will encounter resistance at about $83.00. You see that you can sell an $85.00 strike call for $0.50. If you decide to buy the 1000 shares of MER, you could sell 10 contracts, reducing your basis in MER to $75.63. (Note: For the purposes of this article, we'll ignore commission cost, but they shouldn't be ignored in real life. In fact, one brokerage I once used charged fees so large that it was not possible for me to employ collars. I didn't stay with that brokerage too long.)

Reducing your basis to $75.63 assuages your concerns some, but what if markets plunge overnight some night and you wake up with MER gapping below $70.00? You'd like a bit more protection. As it turns out, as we know from our end-of-week perspective, that protection was going to be needed.

What if, instead of using that call premium to reduce your basis, you spend it on extra protection? What if you use it to either pay for or reduce the cost of an out-of-the-money put?

Near-the-Money Put Prices with MER at 76.13 @ 1:09 pm on 7/30:

Unfortunately, you find that the recent volatility has pumped up put prices. Puts are so expensive that your $0.50 sold call premium wouldn't offset the price of those puts much. It would be too expensive to establish a collar.

What if you sold the $80.00 strike call for $1.40 instead and used that to buy the $70.00 put at $0.95? You'd reduce your basis in MER to $75.68 [$76.13 MER cost - ($1.40 credit for sold call -$0.95 cost for purchased put)]. You'd be able to participate in gains only up $80.00, the strike of your sold call, but, unfortunately, you'd have risk all the way down to $70.00, the strike of your long put.

Is that a good risk/reward scenario, risking $5.68 ($75.68 basis - $70.00 strike) to participate in gains up to $80.00? Maybe that wouldn't be such a good risk for some people.

However, that depends on how strongly you feel about MER's bounce potential and your view on the timing of any potential climb. For example, if you believe that MER will climb surely but slowly while the VIX declines and options cheapen, you might benefit from an increase in the stock price without the stock being called away.

Let's think about an imagined scenario. What if MER has risen to $78.00 four days before option expiration? What if volatility in those options, at 43.29 on 7/30, dropped to 30.00 as it rose into opex week? As of 7/30, when these calculations were being made, my brokerage calculates a theoretical value for that sold call at $0.31 if MER has risen to $78.00 four days before opex. You would have several choices. Perhaps you're grateful in the current environment for have chosen a stock that gained, but now you've had enough excitement and want out. You could buy back (buy to cover or buy to close) that sold call for $0.31 and then sell the stock for $78.00. This transaction would net you $77.69. Since your basis was $75.68, you've gained $2.01.

Maybe, in this supposed scenario just before option expiration when MER has risen to $78.00, you're still reasonably confident that MER will move higher. Instead of buying back the AUG 80 call, you decide to roll up and forward into a September call. My brokerage calculates the theoretical value of a September 85 call (moving up a strike) at $0.90 four days before August opex with MER at $78.00. Theoretically, then, you could roll out of the August 80 call and sell the September 85 for a $0.59 gain (buying to close the AUG 80 at $0.31 and selling the September 85 for $0.90), although I'd figure a little less because you're going to be splitting bid and ask prices at an advantage to the market maker, not you. Imagine, however, that you could roll into that September $85.00 strike for a $0.50 gain. Are you going to use it to again reduce your basis or to collar the stock price again?

If MER had theoretically risen to $78.00 four days before option expiration as the implied volatility in MER's options dropped to 30.00, in our imagined scenario, my brokerage calculates a theoretical value for that Aug 70 put at 0.01. Selling to close that put isn't going to garner you anything to help with the purchase of a September put. You have only the $0.50 that you gained from rolling into a September call to spend on a protective put. My brokerage calculates the theoretical value of a September 70 put at $0.45 under our imagined conditions. You have more than enough to buy that put, but that keeps your risk down to $70.00, when that long put's protection kicks in, and the stock has risen, in our imagined scenario, all the way to $78.00. A September 75.00 put would cost you $1.60, significantly more than the $1.60 you garnered by rolling forward and up into a September 85 call.

Of course, we know now, as of about 10:20 on Friday, August 3, as this article is completed, that MER didn't bounce. Continued bad news from financials pummeled this financial along with others. As of about 10:20 that morning, MER was at $70.90. Let's see what would have happened to your option prices. Would that collar have helped you?

MER's Near-the-Money Call Prices on Friday, August 3:

MER's Near-the-Money Put Prices on Friday, August 3:

With MER at $70.90, you could buy to close your 80-strike call for $0.40, sell-to-close your MER stock, and sell-to-close your 70-strike put for 2.05. You would net $72.60 [70.90 + (2.05 put credit - .35 call debit to close)]. Your basis, if you remember from the earlier discussion, was $75.68, so your total position has suffered a $3.08 loss ($75.68 - $72.60). That's a loss of 4 percent from your original basis, but it's certainly less than the 6.9 percent loss you would have suffered without the collar.

Whether a 4 percent loss is the maximum you're willing to take depends on your account-management practices. Whether you'd exit the play at this point depends on those account-management practices and your outlook for the stock. I can't answer those uncertainties, but I can say this with certainty: although the high volatility had plumped up options prices, making conditions for the establishment of a collar less than optimal, that collar ameliorated the losses that otherwise would have occurred.

Can you imagine a condition under which it wouldn't have helped as much? Sure. How about if MER languished between $70.25 and $71.25 for the next two weeks, settling on option expiration day back at $70.90? The sold call would expire worthless, but so would your protective put, and there you would be with MER at $70.90, and you having purchased it at $75.68 (the basis with the collar). Although your 6.3 percent loss would still be less than the 6.9 percent loss if you hadn't had a collar, when the basis was $76.13, I'm thinking that small difference might not have been a huge comfort.

Another concern exists, of course, one that did not confront you in this week's action: what would have happened if MER had risen quickly and that sold $80.00 call had gone in the money? You would have had danger of assignment, then, once the extrinsic premium of the call dropped below about five cents. That shouldn't be a problem since you do own the stock, but that should be considered.

Collars prove helpful attire, then, but they're not going to magically get you admitted into the environs of the big money people, either, if you don't know all the secrets about collars. Spend some time studying them. Right now is a great time to run a few scenarios like this one, pricing out a collar using both front month (AUG) and next-month (SEP) options, and seeing which works out best or if they help at all.

While you're add it, compare the tactic with your gains or losses if you just purchased a protective put without going through the collar business. The supposed benefit of the collar is that the sold call pays for much of or all of the cost of the protective put, but decide, after running some of those scenarios, if you agree.

Keep in mind that collars are not going protect you from all losses, but run some real-world scenarios to get a feel for them. They certainly have a place in your trading repertoire.

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