Learn how adjusting a collar strategy—a covered call with a protective put—can help you manage stock risk.
The stock market fluctuates with new highs and new lows. So protective puts and other option strategies designed to defend against downside moves may not always be foremost in every investor’s mind. Corrections happen in every market; it’s only natural.
If you are an options trader, perhaps now is a good time to consider accessorizing your stock position with a collar. Or, if you’ve already been using collars to attempt to protect a stock position, a bull market may be a good time to make collar adjustments.
The basic collar is constructed of three parts: the stock, a long out-of-the-money (OTM) put option, and a short OTM call option with the same expiration date. The put is there to help protect you in case of an adverse move downward in the stock. The premium collected from selling the call can help pay for the put. For example, suppose a stock is trading at or around $100, and the 90-strike put and the 110-strike call are both trading for $2. In this scenario, you could sell the call and buy the put for no net premium outlay (what’s known as a “zero-cost” collar). But don’t forget to include transaction costs in your calculation.
For all of these examples, remember to multiply the option premium by 100, the multiplier for standard U.S. equity option contracts. So an option premium of $1 is really $100 per contract.
Also note that these examples do not account for transaction costs or dividends. Transaction costs are important factors to consider when evaluating any options trade.
The risk profile of this collar is shown in figure 1. It’s worth noting, however, that OTM call strikes typically trade at a lower implied volatility than equidistant OTM put strikes, and thus often trade at a lower premium. So you may need to choose either to alter your strike choice, or accept a bit of premium outlay.
FIGURE 1. RISK PROFILE OF A COLLAR.
The risk profile of a 90-110 zero-cost collar with the stock at $100. For illustrative purposes only. Past performance does not guarantee future results.
Options don’t need to be held all the way through expiration. If the stock moves before expiration, you can consider adjusting or even closing the collar. If you can, think of your put option as a floor, and the call option as a ceiling. In a market that’s moving higher, you can make adjustments to raise the floor and/or raise the ceiling to accommodate the rising stock.
Let’s say the stock moves up to $105 after two weeks. Using the prices from the sample option chain below, you could use a long put spread order to roll your 90 put up to the 100 strike for $1 ($1.20 – $0.20), plus transaction costs.
Your put protection would now be $5 below the current price of the underlying stock. Note that, in this example, the call is still OTM by $5, and if the stock remains below the 110-strike through expiration (but above the 90-strike), both the call and the put will expire worthless.
If the stock rallies, however, you may be assigned, which means you’ll likely need to sell your stock at the call’s strike price. But because you would have held the stock from $100 to $110, that represents a $10 gain. However, you’ll miss out on any of the stock’s appreciation beyond the 110 strike price.
Alternatively, you could consider rolling the call to a longer-dated option, perhaps a higher strike. And if you're still interested in protecting the downside, you could also consider rolling the long put. This is a strategy employed by many option traders. For more on rolling option positions, please refer to this primer.
And what about the opposite case—if the underlying were to move down after initiating the collar? In a future article we’ll look at other adjustments you could make with your collar.
for thinkMoney ®
Financial Communications Society 2016
for Ticker Tape
Content Marketing Awards 2016
Rolling strategies, spreads, and other multiple-leg option strategies can entail additional transaction costs, which may impact any potential return. These are advanced option strategies and often involve greater risk, and more complex risk, than basic options trades.
The covered call strategy limits the upside potential of the underlying stock position, as the stock would likely be called away in the event of substantial stock price increase.
Market volatility, volume, and system availability may delay account access and trade executions.
Past performance of a security or strategy does not guarantee future results or success.
Options are not suitable for all investors as the special risks inherent to options trading may expose investors to potentially rapid and substantial losses. Options trading subject to TD Ameritrade review and approval. Please read Characteristics and Risks of Standardized Options before investing in options.
Supporting documentation for any claims, comparisons, statistics, or other technical data will be supplied upon request.
The information is not intended to be investment advice or construed as a recommendation or endorsement of any particular investment or investment strategy, and is for illustrative purposes only. Be sure to understand all risks involved with each strategy, including commission costs, before attempting to place any trade. Clients must consider all relevant risk factors, including their own personal financial situations, before trading.
This is not an offer or solicitation in any jurisdiction where we are not authorized to do business or where such offer or solicitation would be contrary to the local laws and regulations of that jurisdiction, including, but not limited to persons residing in Australia, Canada, Hong Kong, Japan, Saudi Arabia, Singapore, UK, and the countries of the European Union.
TD Ameritrade, Inc., member FINRA/SIPC. TD Ameritrade is a trademark jointly owned by TD Ameritrade IP Company, Inc. and The Toronto-Dominion Bank. © 2019 TD Ameritrade.