Explore Your Options
Got a question about options? Tom Gentile is the chief options strategist at Optionetics (www.optionetics.com), an education and publishing firm dedicated to teaching investors how to minimize their risk while maximizing profits using options. To submit a question, post it on the STOCKS & COMMODITIES website Message-Boards. Answers will be posted there, and selected questions will appear in future issues of S&C.
Tom Gentile of Optionetics
CREDIT SPREAD TO COLLAR SPREAD?
I have heard of using a credit spread to get into a collar. This makes sense to me, but I'm not sure when to make the adjustment. Is it better to do it before or after expiration?
Rolling a credit spread into a collar is a reasonable strategy in certain situations. Let's first consider using puts to buy stock and then look at put credit spreads. If you have a bullish view on a stock and are willing to buy it at a lower price from where it currently is, you might sell puts with strike prices below the current stock price and pocket the premium. If the stock falls, you get assigned on the puts and acquire the stock at the strike price of the put option. This is a common strategy that is used relatively often.
However, I prefer to sell puts as part of credit spreads because it involves less risk. For example, if the stock I like is trading for $45 a share and I sell the January put with the 40 strike price, I receive premium for selling the put. In this case, I am holding a naked put because there is no other position to offset the risk from the put option. Let's say I sell the put for $1.50. If so, the maximum profit I can earn from selling one put is $150 ($1.50 x 100). I can keep that profit if the stock stays above $40 a share and the put expires worthless. If the stock falls below $40 a share, I get assigned and that's okay because I am willing to buy the stock at that price. Some traders refer to this as a "sell to buy" trade.
How much do I stand to lose? Well, in the worst-case scenario, the company goes bankrupt and the stock falls to zero. In that case, I am on the hook for $40 a contract because my put will get assigned to me at $40. The premium from the put sale ($1.50) will offset some of that loss, but I am still saddled with a loss of $38.50 or $3,850 for one contract. I am taking in $150 in premium and risking $3,850.
Now, instead of selling a naked put, let's say I sell the January 40 put for $1.50 and hedge some of that risk by purchasing the January 35 put for 50 cents. In this case, I set up a spread, sometimes called a "bull put spread," for a credit of $1.00. Just as with the naked put, I want the stock to stay above $40 a share and the options to expire worthless. In that case, I keep the premium, or $100 per spread.
At the same time, unlike with the naked put, my maximum possible loss is much less because I am protected by the long put. Say, for example, the stock falls to $10 a share. With a naked January 40 put, I get assigned and my loss is equal to $30 per contract minus the premium, or $28.50 ($2,850 total). However, if I hold the January 40/35 put spread and the stock falls to $10, the most I can lose is $400 because when I get assigned on the 40s, I can exercise my put option to sell the stock at $35. I am forced into a loss of $5.00 per spread, but that loss is offset by the initial credit of $100. So my loss is $400 instead of $2,850.
Now, let's assume that the stock doesn't fall as dramatically and falls to $39 a share. Expiration is approaching and I expect assignment. (All options that are in the money are automatically assigned at expiration.) That's okay, because I am willing to take ownership of the shares at $40. In addition, now I want to take my credit spread and roll it into a collar.
The collar strategy, you will recall, is a bullish trade with limited risk that involves owning shares, selling calls, and buying puts. The strategy is a combination of a protective put and a covered call, where the sale of the call options can help to offset part or all of the cost of the put option.
In this example, after expiration and assignment, I own the stock for $40. In this case, since expiration is always on a Saturday, I did not let my long put expire worthless. Instead, I rolled it to March because I wanted to keep a hedge in place. So, before expiration, I closed out the January 35 put and bought the March 35 for a net debit of $1.00 a contract. If I simply let the January 35 expire, I am left holding shares unhedged over the weekend. The purpose of collars and credit spreads is to stay hedged.
On Monday, the stock is trading for $39 and I now hold the March 35 put. I was assigned at $40, but also received $1.00 in premium from the initial credit spread. So my cost basis for the stock is $39. However, I also bought the March 35 put for a net debit of $1.00. So my cost basis for the shares and put is $40.
I am not finished yet. On Monday, once I have the shares and the long put, I also sell a March 45 call for $1.00 to create the collar. The cost basis for the total trade is now $39, or the current price of the stock. My downside is limited to $400 because I have protection from the long put and my upside is also limited, with the possibility of making $750 if the stock makes a move up to $45 a share at expiration. I am now risking $400 to make $750.
Why didn't I simply enter the collar in the first place? There are times when it makes more sense to start with the collar. However, what if I can enter several successful credit spreads before getting assigned on the short puts? It can create a nice income stream that will help lower the cost once assignment forces the adjustment into a collar.
Originally published in the September 2008 issue of Technical Analysis of STOCKS & COMMODITIES magazine. All rights reserved. © Copyright 2008, Technical Analysis, Inc.
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