Equivalent Positions II: Tying It All Together

If you are new to the world of options, today discussion may appear to be a bit confusing. But if you go slowly and re-read the linked posts, you’ll understand the discussion.

If you’ve been trading options for awhile and never bothered to learn about equivalent positions, this post contains information that can make your trading more efficient.

Here is summary of some recent blog posts:

  • Some option positions are equivalent to others, and covered call writing is equivalent to writing naked puts.
  • To significantly reduce the risk of writing naked puts, turn it into a credit spread by buying a put that is further out of the money than the put sold.
  • Collars are a good, conservative strategy for any conservative investor.

Let’s take a closer look at a collar, which consists of three legs: long stock, long put, short call. ZZY is trading at $67 per share and you want to collar that stock. To do that you may decide to write one Dec 75 call and buy one Dec 60 put.

Separating the collar into two parts:

Collar: Part One

Part Two

Long 100 shares of ZZY           Long
1 ZZY Dec 60 put

Short 1 ZZY Dec 75 call

Part one is a covered call position, and we know that a covered call is equivalent to being short the put with the same strike and
expiration.

The collar, part one is equivalent to:  Short 1 ZZY Dec 75 put

The collar, part two is:  Long 1 ZZY Dec 60 put

This position is a put credit spread (short a put and long a put with a lower strike price).

So what, you ask? This is proof that the collar position is equivalent to the put credit spread – but only when the put owned is the same and the put sold has the same strike and expiration date as the covered call.

If the conservative approach offered by collars appeals to you, consider selling the put credit spread instead. First, there are fewer commissions to pay, and second, the put spread is easier to trade because there are only two legs in the position, instead of three.

NOTE to more experienced traders: The collar is also equivalent to buying the bull call spread, when the strike prices and expiration date are the same as the puts that are part of the put credit spread. In other words, buying the ZZY Dec 60/75 call
spread is equivalent to selling the ZZY Dec 60/75 put spread.

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