What can an investor or trader do if they have experienced a nice run up in a stock and would like to protect their unrealized profits? Or perhaps a stock has been tracing out a technical pattern which, if the support area were broken, could lead to further downside (Head & Shoulders, Descending Triangles).
One way to get “cheap” stock insurance is to use an option strategy called a COLLAR. For each 100 shares of stock owned:
- Buy 1 Put option – gets you the insurance
- Sell 1 Call option – you collect premium which offsets part or all of the cost of the put
A common construction is to place the strike price of the put option close to the price of the stock and the strike price of the call option above the price of the stock, as in the following example:
Stock XYZ is trading at $125. Collar is created by buying the 54-day $120 Put for $3.90 and selling the $135 Call for $2.45. Net cost of the collar is $1.45. Because the long put provides the right to sell the stock at $120, the maximum risk for the trade is $6.45 ($1.45 cost + $5.00 decline to $120 strike).
In exchange for the “cheap” insurance, the stock owner has agreed to sell the stock at $135 should the stock close above this price at expiration (the option will be assigned).
Three things you should know:
- If you are not willing to sell the stock at the strike price of the sold call, you will either have to buy back the call or roll it out to a further expiry.
- You do not have to hold on until expiration. If the stock drops earlier than expected, you can “cash in” the insurance by selling the put and either buying back the short call or leaving it with the hope that it will expire worthless.
- Try to use collars when necessary, not constantly – they will cost you money over time and cap your upside if the stock breaks out.
If the collar is constructed with options of equal premiums, the trade is called a “Costless Collar.” There are variations of the Collar; each having its unique behavior and position management requirements.
