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.
I read some messages from other traders about collars and I’m confused. My understanding is these were a bearish strategy, but above all they’re for insurance on your stock. What I don’t understand is many forum contributors advise that collars are a bullish strategy! Sure, I want my stock to go up ...but if I’ve already got stock, then taking out a collar seems impossible to make money in a bullish market (over and above a gain in stock price). If my puts keep expiring worthless, and I have to keep buying my calls back at a higher price and then selling the next month, it’s going to cost me a fortune! All my profit from the rising stock is being eaten up by rolling up my calls!
Your understanding of collars is correct. The trade is created by selling calls and buying puts. Without any stock, the strategy is bearish because both short calls and long puts have negative deltas. Therefore, they will decrease in value as the stock moves higher and increase in value as the stock price moves lower.
Since the collar consists of long shares and puts along with short calls, it can also be viewed as a protective put (shares protected with puts) along with short calls. Or it can be considered a combination of a protective put and a covered call (buying stock and selling calls). The calls help pay for the puts, but also limits the upside.
When creating a new collar (buying out-of-the-money puts and shares while selling out-of-the-money calls) or putting a collar around an existing stock, the trade has a bullish risk graph. The protective put strategy is the synthetic equivalent of a call option, which means it has the same risk graph. Both the protective put and buying calls are bullish trades with limited risk and, theoretically, infinite potential rewards.
When you create a protective put and sell a call with a higher strike price, you have entered the equivalent of a bull call spread. A bull call spread is a strategy that involves buying calls and selling calls with a higher strike price. The collar and the bull call spread have the same bullish risk graph.
Profits from both trades are made when the stock price moves higher, due to the fact that the protective put (or long call) will increase in value faster than the short call will lose value. The trade has a positive net delta.
True, if you continually roll the position to higher strike prices as the stock moves to the upside, the puts might expire worthless while you pay higher prices for the calls to buy back the short calls. However, the gains from the shares more than make up for the loss. In addition, keep in mind that the calls will also lose value due to time decay; the shares won’t. If the stock makes a dramatic move higher, the short calls will be assigned and, in most cases, the result will be a gain on the trade.
Let’s put some numbers on it and look at a recent example of a collar on an exchange traded fund called the iShares Xinhua China Index Fund (Fxi). The fund was trading around $25.30 per share a few weeks ago and it would have been possible to create a collar using May 20 puts and May 30 calls. Both were trading for $0.85 and if I had created a collar, the sale of the calls would have completely offset the cost of the puts. I paid $25.30 per share.
The downside risk through the May option expiration was limited by the strike price of the put (20.9%) and the upside capped by the calls (18.6%). If Fxi moved below $20, I could have exercised my put and sold the shares for $20, no matter what happened. If it moved significantly beyond $30, I would have faced assignment and been asked to sell the shares at $30.
What would have happened if Fxi moved up to $29 at May expiration and I wanted to create another collar? I would have had a $3.70 profit on the shares ($29 - $25.3) and both the puts and calls would have expired worthless for a loss of $0.85 and $0.85, or $1.70. My profit would have been $2.00 per share, or 7.9%. I could have bought more shares or created another collar, perhaps selling the 35 calls and buying the 25 puts. As we can see, the profit from the trade would have come from the appreciation in the shares, and some traders would have used it as a tool for accumulating more shares over time.
Expire Or Exercise?
I bought 10 Xyz March 16/17.5 call spreads for $0.20 a while ago. The spread is now worth $0.02. Is it okay to just let it expire this weekend? Or will I have to pay the difference between the strike price and the stock price at expiration ?
It sounds like you gambled and bought an out-of-the-money spread for $0.20 and now hope that the stock moves up to $17.50 by March expiration to make $1.30. It sounds like the stock didn’t make the move you anticipated. If all of the contracts are out-of-the-money (meaning the stock price is below the strike price), they will expire worthless.
On the other hand, if both stocks moved above $17.50 at expiration, both options would be exercised and $150 per spread (the difference between the two strike prices) would be credited to your account. Finally, if the stock closes between the two strike prices, or $16 and $17.50, the $16 call would be exercised. Your account will be credited 100 shares at $16, and debited for $1,600 per contract plus exercise fee. You would then have some risk associated with holding the shares over the weekend and when the markets open Monday.