March 30th, 2009Portfolio Protection And Adjustments With Stock Option Collars
Covered calls are great for reducing risk in your portfolio, as well as potentially enhancing your returns. But the amount of protection provided by a covered call is often not enough for today’s insanely volatile markets. When you need more protection than the covered call will offer you, it’s time to consider the stock option collar.
Where a covered call will LIMIT only your GAIN on an investment, an option collar will LIMIT BOTH YOUR GAIN AND YOUR LOSS. A covered call is a 2 legged position – shares of an underlying stock in 100 share increments, and the SALE of a CALL OPTION against those shares. An option collar starts off as a covered call, but adds the PURCHASE of a PUT OPTION for added protection on the downside.
Consider the example below in the geldpress option calculator, which can be downloaded here. The top section entries (top arrow) is where the option collar simulation starts, with the following criteria shown in the example:
- 100 stock price
- 40 days until option expiration
- Selling a 105 strike covered CALL
- Buying a 95 strike PUT option
- Assumed 1% risk free rate of return and a 45% volatility on the underlying (normal in today’s market)
Notice that the effective cost of implementing an option collar is almost ZERO. The cost of the PUT option ($359) is essentially financed by SELLING a higher strike covered call ($395). At expiration, the gains on the stock are capped beyond $105 (the covered CALL strike). And the losses are capped below $95 (the PUT strike).
The simulation of all three legs (stock, covered call and put) of the option collar are shown above, assuming a stock price drop from $100 to $90, and time to expiration going from 40 days all the way to expiration (left to right).
With the collar in place and 20 days before expiration, and a $10 price drop, here is what happens:
- The loss on the stock position is $1,000 (100 – 90)
- However, the protective PUT gains in value by $326 (685 – 359), And…
- The covered call decreases in value by $362 (395 – 33), But…
- A decrease in a SOLD COVERED CALL is an INCREASE in value to the SELLER (you).
- Despite the $1,000 stock loss, the protective collar limited your loss to only $312
And the real beauty of the option collar is the ability to adjust your position by doing one or more of the following, depending on your trading style:
- Removing the collar and going naked
- Removing a portion of the collar (selling the put, *OR* buying back the covered call)
- Resetting the collar to new strike prices
- Moving the expiration of the option collar legs further out in time
For other ideas on Options Adjustment Techniques, BUY THE FOLLOWING BOOK:
Feel free to download and modify the tool to your liking, but remember, use at your own risk. There are NO guarantees.
Also check out:
- Time for cover – the covered call
- Covered calls – removing the covers and going naked
- Bring Your Collar Into These Volatile Markets
- Married Puts, Collars, And Hybrid Hedging
- Model A Stock Option Collar With Op-Eval Pro Software
For a detailed guide on building OPTION PRICING Applications in Excel, BUY THIS BOOK.