Collars: Revisited

It's time to take a fresh look at collars.  In mid-2008, we wrote about collars and how they work.  As a reminder, a collar position consists of owning 100 shares of stock, one (almost always an out of the money) put option, and being short one out of the money call option.

The purpose of owning this position is to limit losses when the market falls.  The trade is slightly bullish and there is limited upside profit potential.

This is one option strategy that is preferred by those who want to protect their holdings from a devastating market decline.  It's very effective because losses are limited (the collar owner maintains the right to sell shares at the strike price of the put he/she owns).  There are two reasons that this type of portfolio insurance is so appealing:

  • It almost always costs no cash out of pocket to own the collar.  That's true when the investor collects as much cash when selling the call option as it costs to purchase the protective put option
  • This position provides both safety and the opportunity to earn a limited profit.  Investors who only buy puts must pay the heavy cost and have little chance to earn any money, unless there is a significant rally

Experienced option traders are probably aware that owning the collar is equivalent to two other positions, each of which is a popular strategy on its own.  However, many novice traders do not recognize that they may be trading collars in a different format:

  • Selling an OTM put spread
  • Buying an ITM call spread

Example (this is an example and NOT a recommendation) 

The Traditional collar:

Buy 100 shares of AAPL, paying $300 per share [$300 is not current price]

Buy one AAPL Dec 280 put

Sell one AAPL Dec 320 call

Sell the put spread – the equivalent position:

Buy one AAPL Dec 280 put

Sell one AAPL Dec 320 put

Buy the call spread – the equivalent position

Buy one AAPL Dec 280 call
Sell one AAPL Dec 320 call

For each of these three trades:

Maximum profit occurs when AAPL is above 300 at expiration
Maximum loss occurs when AAPL is below 280 at expiration

Profit and Loss are the same for each of the three positions when the options are priced efficiently.


So What?  Who cares?

I approve of collars.  I believe they are an appropriate strategy for protecting a portfolio.  However, I know that some people adopt strategies without understanding how they work.

The point that I want to make today is that the collar looks good – and is good for the appropriate investor/trader.  However, many people who adopt collars would never sell a put spread nor buy a call spread.  Yet, they are making the identical trade.  It's important to recognize what you are truly trading.

Some collar traders would be better served by adopting one of the alternative strategies.  The margin requirement is low and trading a position with two legs is far more cost efficient than trading one with three legs. I suggest that collar traders make an effort to trade the corresponding call or put spread in place of the collar.

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11 Responses to Collars: Revisited

  1. Ron 10/20/2010 at 3:54 PM #

    Mark,
    I really have a desire to learn how to trade options for monthly income. What I am finding with many of the books about Options are they only discuss trading options on individual stocks. I’d like to learn how to trade options on index’s or ETF’s mainly because I do not have a strong stock picking background.
    Do you have any suggestions? (BTW, that was a great analysis of collars).
    Ron

  2. Mark Wolfinger 10/20/2010 at 7:52 PM #

    Ron,
    Yes, I have a suggestion. Just do it.
    The strategies are the same, regardless of whether the underlying is a stock or ETF. If you cannot decide which ETF to pick, or which segment of the market to use – then go with one of the big ones: SPY represents the S&P 500 and is the best choice if you want to trade the shares of large companies.
    QQQQ represents the stocks in the NDX 100 and IWM represents the Russell 2000 index.
    Pick one. Find the strategy you want to trade and use it for your ETF.
    Regards

  3. Ron 10/21/2010 at 1:36 AM #

    Thanks for your suggestions,
    Ron

  4. Alex 10/22/2010 at 10:23 AM #

    Is there an online source that displays the current volatility of a specific option? I can find on a stock but not on the option itself. Does this exist?
    Scanning for high vol on options prior to earnings report to write against for vol drop.
    Thanks

  5. Mark Wolfinger 10/22/2010 at 9:49 PM #

    Alex,
    Let’s be certain we have our definitions straight:
    Options do not ‘have a volatility’ that anyone measures. I’m pretty sure you don’t really want to know the volatility of an option. I assume you want to know the ‘implied volatility’ of an option.
    That data is readily available. Your broker should supply it at no cost to you. If not take a look at ivolatility.com
    Stocks have a volatility because it’s a measure of just how much the stock has moved in the past. It’s a historical measurement. The same data can be applied to an option, but it’s not useful information.
    Writing calls on high vol options prior to expiration can be a winning play. But, please understand: Sometimes stocks make violent moves when news is released. This strategy is fine, if used judiciously. Small trade size and picking your opportunities carefully.
    This is a high risk – high reward play.

  6. amir 02/12/2011 at 3:48 PM #

    Mark,

    I have few questions:

    What do you think about using a deep in the money long term (9 months – 1 year) call option instead of buying the stock in a collar strategy? every 2 -3 month you sell the call and purchase another long term call.

    What do you think about buying longer term put option (6 month for example) and selling monthly call option against it in a collar strategy? since we want to sell “time value” and be long intrinsic value.

    Do you sell index credit spreads on a regular basis, say each month for a monthly income or you sell them only when the volatility is high (vix is above 20 for example).

    Thanks

    Amir

    • Mark D Wolfinger 02/12/2011 at 5:43 PM #

      Amir,

      1) Good idea to own a LEAPS options as a stock substitute. But only when it is deep in the money (DITM). So I like your idea.
      However, there is no reason to replace it so frequently. As long as it remains DITM and the time premium is not large, there is no reason to replace it. In my opinion, I’d only do that replacement when the stock started to decline in price and the (now less than 9-12 month) call’s delta is falling instead of slowly moving towards 100.

      2) Very risky. I do not like it at all. I have blogged on this previously.Here is one example.

      This is not a horrible thing to do, and there are some advantages, but please – you must understand the risks before making this play. the basic risk is that the very expensive put loses so much money, that it kills your whole play.

      3) I still sell index credit spreads. But, I sell fewer when IV is low and when I also fear that it will increase in the coming couple of months. I have that fear now, so I manage risk before the trade is entered. I just keep more spare cash, recognize that my maximum earning power is reduced, and sleep better. If I don’t have that fear, I still trade smaller size, but not quite as small. Right now I am only half my usual maximum.

      Good questions

      • amir 02/12/2011 at 11:40 PM #

        Thanks Mark for your prompt reply. After reading two of your books and this blog, I must say that options trading are becoming less scary and more appealing to me, so thank you.

        I’ll explain my logic regarding my second question – buying longer term put option (6 month for example) and selling monthly call option against it in a collar strategy.

        I trade index futures, Emini S&P (symbol: ES) and Emini Nasdaq (NQ).
        The CME provides margin discount for Inter Commodity Spreads, so in this case :
        E-Mini S&P 500 (ES) vs.  E-Mini Nasdaq 100 (NQ) – 1 vs. 2 – 85% credit

        I believe that the Nasdaq will outperform the S&P so I’m long 2 NQ and short 1 ES (that’s my “portfolio”). Now lets add the options to the soup as follows:
        Sell 2 OTM CALL (NQ)
        Buy 1 OTM PUT (NQ)

        The credit from selling 2 calls will cover the cost of the put.
        Is the basic risk as you explained (the very expensive put loses so much money, that it kills my whole play) will be applied to this situation too?

        If the market will drop, 1 Emini Nasdaq contract is protected by the put option and the second Nasdaq contract is hedged via the short Emini S&P contract ( value of 1 point NQ is $20; value of 1 point ES is $50).

        What do you think? can it work?

        Thanks again

        Amir

        • Mark D Wolfinger 02/13/2011 at 12:55 AM #

          Amir,

          When replying to these questions, I never know anything about the trader. How long have you been trading? Have you been using options for a few years, or are you in the very early stages of learning?

          “Less scary” is very good. But please do not become overconfident.

          Almost anything ‘can’ work. For me this is a complex issue and the reply required a lot of time. I’m going to use it Tuesday for a blog post.

          Regards

  7. Samuel 02/15/2011 at 12:15 PM #

    Hello Mark:

    Thanks for your wonderful books and also the time you take to answer all questions. I thoroughly enjoy your site.

    I have been trading Stocks for over 10 years and options for the last 5 years. I would classify myself as a conservative investor (34 year old software engineer by profession).

    From last 2 years, I have been trading Iron Condor’s exclusively. I primarily sell/trade front month options trying to utilize the decaying Theta. I enter a call spread the day when the market is up and enter the Put Spread when it is down. I stick to selling Strike’s where the Delta’s are 0.10 or less, and I try to let them expire worthless. My Stop Loss is when the Delta’s go more than 0.24. In the last 24 months, this strategy has produced me 1 losing month (2% Loss) and 3 breakeven months.

    Is there anything that you would suggest that I could improve on in this strategy or do differently?

    Forgot to mention – I primarily stick to Index funds and mostly SPY or IWM

    Thanks,
    Samuel

    • Mark D Wolfinge 02/15/2011 at 12:35 PM #

      Samuel,

      20/24 winning months speaks for itself. There’s not much for me to say. Congratulations.

      What I like about your methods

      You have an exit plan to manage risk

      You have had great success

      When all is said and done, those two factors are the entire ball game, and if I were in your position, I would not change anything

      What I don’t like about your methods

      trading front month options is a high risk/high reward play. Too risky for me, but you must define your own comfort zone

      positive theta may be a good thing, but negative gamma is far worse. Think about where you would have been had you started four or five months earlier

      legging into iron condors is not as rewarding as you think it is

      check to see how much more you collect for the call spread when you sell at a higher price and decide if it’s worth the risk of missing the sale

      If the market does not go your way, do you ever sell the other side of the iron condor?

      You just missed the disaster time frame for iron condor traders by starting in early 2009. Please be aware that the markets are not always so kind

      It seems to me that you know what you are doing. If you don’t get overconfident and if you maintain discipline (by that I mean good position size) you should do well – if you can survive those inevitable volatile periods.

      Thanks for sharing