Option Investor
Trader's Corner

Tailoring Collars

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Many investors wish they or their investment advisers had known more about collars before last year. Many who do know about collars don't know that they come in many sizes and shapes, too, to achieve all sorts of purposes. This article discusses some variations on the basic or traditional collar position.

Those who have never employed or studied the standard or no-cost collar position will find an introduction to this position on pages 276-280 of Lawrence G. McMillan's tome, Options as a Strategic Investment as well as in my own Options 101 article of November 28, 2008. That standard collar involves selling a slightly out-of-the-money call against a stock or LEAP position, and then using the proceeds of the call sell to offset or mostly offset the purchase of a slightly out-of-the-money put. For most stocks, one contract of the call would be sold and one of the put bought for each 100 shares of stock. The investor attempting this standard collar searches for a combination in which the credit received from the sell of the call option offsets or mostly offsets the purchase of the long put position.

Finding that magic combination in this market environment can be a little tougher than usual. As McMillan warns, care must be taken to factor the debit for the collar into the trade, to determine if it's a worthwhile position. As noted on page 840 of McMillan's book, the 1987 market debacle permanently changed the volatility skew of puts and calls, so that out-of-the-money puts tend to be more expensive than out-of-the-money calls, relatively speaking. Still, the investor who is determined to put on the collar at no cost can find a sold call plus long put combination that works.

A no-cost or low-cost collar offers limited participation in upside potential of the long stock position but also limits losses. The maximum loss would be the distance from the current stock price to the strike of the long put plus any debit and commissions paid for the collar, if a slight debit was incurred. Overall losses are limited, and the investor avoids an emotion-based decision to sell stock in the middle of a steep decline. McMillan notes this benefit, saying that being forced into an emotion-based sell of a long stock position would result in locking in a much bigger loss.

The CBOE site offers a comparison of an unprotected long equity position (dark blue) versus a collared position (mauve) in the following chart:

Protective Low-Cost Collar:
[Image 1]

The astute among the subscribers will notice that the profit/loss chart for a collared stock position has the same profile as a bull call spread. Both enjoy limited risk balanced by limited upside potential.

Other types of collars can be constructed, however, to achieve other purposes. McMillan suggests that the investor who does not want to "forsake all of the profit potential" from the long stock position might buy enough puts to protect the whole position but not sell calls against the whole position. For example, an investor who wanted to protect 1000 shares of IBM stock might buy 10 contracts of puts but sell only 5 contracts of calls, only partially offsetting the purchase of the puts. This offers downside protection but allows for more participation in any upside gain. The downside protection just costs more in this case because it's not fully offset by the sold calls.

The point here is to realize that collars can be flexible. In a webinar for the CBOE titled "Hot Topics for Option Traders: Dynamic Collar Trading," Dan Sheridan suggested another tactic that he felt appropriate for the current market situation (October 23, 2008). If investors felt that a particular equity might have been sufficiently battered that it was ready for a big bounce and the investor did not want to severely limit upside potential if a big bounce did occur, a variation of the collar might be tried. Protective puts that covered the entire position would be purchased. Calls would be sold in an equal amount, but then the investor would also buy a higher strike call in an equal amount, effectively establishing a bear call spread above the equity's price.

The example he provided was of a trade considered on February 25, 2008, with AAPL stock purchased at $120. (Disclaimer: It was not clear, at least to me, whether Sheridan had initiated this trade or was merely using it as an example.)

Sheridan's Suggested Trade for Collar Protection with More Potential to Participate in an Upside Move, Chart from Sheridan Webinar:
[Image 2]

The shape of the profit/loss chart for this variation on a collar shows an important difference from the traditional collar, with that difference showing up on the far right-hand side of the chart.

Profit/Loss Chart for Collar Variation with Bear Call Spread, Chart from Sheridan Webinar:
[Image 3]

Between 125 minus the debit for this trade and 135 plus the debit, this collar variation acted like a typical collar, with the upside participation kicking in but then being capped. Once AAPL climbed past the 135 strike of the long call plus the debit for this collar variation, however, the trade began gaining again.

Sheridan suggested another collar variation in that same webinar, one appropriate for the investor who believes his equity position could tank and who not only wants some downside protection but also wants to gain if the equity does tank. That variation involved adding a couple of extra put contracts to the typical collar.

In a separate "What's Happening in the Markets with Dan Sheridan" webinar for the Options Industry Council on September 2, 2008, Sheridan suggested yet another variation, "The Complete Collar," as he termed it. The complete collar, he said, was appropriate for the investor with a "need to retain stock for tax purposes," who didn't "expect additional upside profit in short-term" time frame and who wanted "total downside protection" over the short-term time frame. This trader would sell an at-the-money call, not an out-of-the-money one, and would buy an at-the-money put. The result, Sheridan suggested, was that the equity gains were locked in or realized, with the trader not caring what happened to the stock. However, as there would be no further position at expiration, Sheridan says, I'm not certain how that protects the investor who can't sell for tax reasons unless the expiration period straddles the end of a tax year.

Perhaps you thought that collars were boring fashion accessories and boring options positions, but it's clear that they can be more exotic than first thought. They can be important tools for the investor, too. This article was not meant to cover all the pros and cons of each of these trades, but rather to convince subscribers that collars can be flexible and to urge an investigation of some of the sources listed here.

Not only can a single stock holding be collared, but an entire portfolio can be, too. That's neither simple nor boring, but it's a topic covered by Steve Lentz in an April 3, 2008 webinar for the CBOE, "Options Strategy Series Part 1: Hedging Featuring Steve Lentz." The points Lentz presents are too complex to be tacked onto the end of this article. Although a future Trader's Corner space might cover some of Lentz's points, viewing this webinar might be a good idea. Pay special attention to Lentz's results when testing whether it's best to use at-the-money or out-of-the-money options for collars and whether it's best to use near-term or longer-term options for the strategies.

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