Collars, Conversions, & Clarity: Limit Risk without Compromise

Chili is just meat, spices, and maybe beans. Simple, right? So how come some people win chili contests and the rest of us just have stains on our shirts? In trading, if you take long stock, a short call, and a long put, what position do you have? Well, it might be a conversion, or it might be a collar. One is interesting knowledge to have in your back pocket. The other is handy in real, live trading. So, if the parts are the same, how are the conversion and collar different?

Good Chili Boils Down To Stock

A conversion is long stock, a short call, and a long put. The call and the put have the same strike price and expiration. A collar is long stock, a short, out-of-the-money (OTM) call, and a long, out-of-the-money put. The call and put may have the same expiration, but, as we'll see later, not necessarily. The conversion is the “nice to know” trade. The collar is the one that many traders are more likely to put on.

Think about the conversion. The short call/long put combo is synthetic short stock, in which the position gains dollar for dollar when the stock moves down and loses dollar for dollar to the upside. Now if you're long actual shares of stock and short synthetic stock, what do you have? A trade whose P/L depends less on whether the stock goes up or down, and more on interest rates and dividends.

A conversion is a “cost-of-carry” trade; interest rates and dividends determine the price of the synthetic stock. So the position is great if its purpose is strictly no-frills stock protection, but as a trade, it's not something that individual investors would have much success with. Transactions costs will more than likely eat up any profit from dividends exceeding the interest rate of holding the stock. In chili terms, it's kind of bland and not very satisfying.

 That Collar Looks Familiar

What makes the collar more practical is that its P/L depends mainly on the direction of the stock price. The stock profits up to the strike of the short OTM call. It loses as it drops to the strike of the long OTM put, at which point, losses in the stock are offset by gains in the put. That's why a collar is a position to establish if you believe the stock might go higher.

Now, if you take the pieces of the collar—long stock, short call, long put—and match them up differently, you can see them as other synthetic positions as well. Take the long stock and match it with the long put. You get a synthetic long call. And if you have a synthetic long call and an actual short out-of-the money call, voila! You have a long call vertical spread. Now, take the long stock and match it with the short call to get a synthetic short put. And if you have a synthetic short put and an actual long out-of-the-money put, that's a short put vertical. The long call vertical and the short put vertical make money if the stock goes up, and lose money if the stock goes down, just like the collar—same risk, same reward. If that's true, you'd be indifferent trading either the collar and long call vertical and short put vertical, right? Well, in real-world trading, no.

If you are currently long a stock position, you just might look to a collar to generate income and hedge the long stock position. Selling the out-of-the-money call generates the income, and buying the out-of-the-money put provides the hedge. These options “collar” their stock.

But if you don't already own the stock, there isn't really any reason to trade into a collar as opposed to, say, a long call vertical. The collar has three commission costs (long stock, short call, long put), while the vertical spread has only two (long call, short call). That, and the capital required for the collar, is the margin on the long stock—typically 50 % of the value of the stock in a margin account. For the long call vertical, it's just the price of the vertical.

Wait! What if the stock pays a dividend? Only long stock positions are eligible to receive the dividend. Long calls get nothing. That means the collar's better on a dividend-paying stock, right? Wrong. If you own a long call, you don't get the dividend unless you exercise it before the ex-dividend date of the stock. Because the call doesn't participate in the dividend, its price is somewhat lower than it would be for a non-dividend-paying stock. A long call vertical on a dividend-paying stock is a bit less expensive, too, so it doesn't really matter whether you buy the call vertical or the collar.

Creating the Collar

Whether you own the stock and want to collar it, or don't own the stock and want to trade a vertical, how do you select the expirations and strikes of the options? If you keep to the idea that the short call is for enhancing returns (or income) and the long put is for protection, it can help you decide which option might be right for your strategy. The two main decisions you'll have to make have to do with how far out-of-the-money (distance) and how far out in time you want to go:

Distance With the collar or the vertical, selling the call generates positive time decay, meaning time is working in your favor as days go by. You sell it, take cash into your account, and if it expires out of the money, you keep that cash as profit on the short call (less applicable commissions and fees, of course). The closer the strike price of the call is to the current stock price, the larger the credit you get when you sell it. But it also limits the potential profit on the long stock position if you're lucky and the stock goes higher. The stock's profit potential is capped at the strike price of the short call. Place the short call strike too close to the current stock price, and you'll cap the profit on the stock pretty quickly. Place the short call far away from the current stock price, and you'll take in a smaller credit. That's the trade-off.

Time Because the short call generates positive time decay, the choice is a balance of the rate of decay and the total amount of extrinsic value. The amount of extrinsic value determines the maximum income you can receive for selling the call. But the rate of decay determines how quickly the position generates that income. The more time to expiration, the more extrinsic value and the higher the credit for selling the call, but the lower the rate of decay. The less time to expiration, the less extrinsic value, but the higher the rate of decay. Balancing those two things will help you determine in which expiration month to sell the call. The strike also affects the rate of decay and the extrinsic value.

How Much Insurance Do I Need?

Because they are similar with regard to risk and potential reward, your approach to determining the strikes for the options in the collar or the vertical is pretty much the same. For the put on the collar, which is also the strike of the long call in the long call vertical, you determine how much protection you want. If you buy a put further out of the money, it will be less expensive, but your stock position will lose more before the long put protection kicks in to offset the losses. Puts that are closer to the money provide more protection, but they also cost more.

One factor is how much you're willing to pay to hedge your long stock position. And, as mentioned earlier, the long put doesn't have to be in the same expiration as the short call. You may want to buy a put in a further expiration, because while it will cost more (all other things being equal), it will have lower negative time decay—as well as more positive vega (vega is the measure of an option's sensitivity to changes in the volatility of the underlying asset). If implied volatility rises when the stock drops, that will drive the value of the higher vega long put up that much more.

Collars and verticals are interesting ways to get started in option trading; they are versatile, provide a hedge, and can provide income. Now if we could just find the perfect recipe for chili.