Collars using LEAPS Puts and Front-Month Calls

I've wanted to return to discussing collars and the investment returns available when using them.  This question gives me an opportunity to begin.


I've just recently begun learning about options and would like to
know what you think about buying shares, buying an at the money LEAPS
put and then selling front month at the money calls against the stock.

I've had no luck searching the web regarding this strategy. Once again,
I'm at the point where I don't even know what I don't know and would
appreciate your feedback.




You are already way ahead of most beginners by understanding that you 'don't know what you don't know.'  It appears to me that you have read about several different principles of using options and are trying to put together a strategy that encompasses several of them.  The problem with options is that one plus one is often unequal to two.

You are trying to adopt the collar strategy, and I don't know whether you realize that.  The collar is a good, conservative method for protecting your assets when investing.

One problem with the typical collar is that you own puts than expire at the same time as the calls.  Thus, the position does not provide anything attractive in the way of time decay, or positive theta.  By owning option that expire in the 2nd or 3rd month, the benefits of theta come into play.  Collars with puts that expire in three and six months, rather than the front month have been shown to outperform traditional collars – at least under the conditions of the specific study.

Your idea is to go whole hog and buy LEAPS puts – to have a very pretty time decay position.  Alas, it's not that simple.

Dave – There is one very serious problem with this strategy, and to me it dwarfs the rest of the discussion.  Your obvious intent with this trade is to pay very little in time decay for your long LEAPS puts and to collect the very rapid time decay by selling near-term calls. 

You do get that nice positive theta.  And if you are lucky, and the price of the underlying doesn't change by too much month after month, this plan works like a charm.

But, you are going to be short gamma.  That front-month call has much more gamma than the LEAPS put.  I don't know what you know about gamma, but it measures the rate at which you get long or short as the market moves.  Your proposed trade has negative gamma.  That means you get shorter and shorter when the market rises.  It also makes you longer and longer as the market falls.

If the market rises significantly:

  • The call moves into the money and quickly moves point for point with the stock.  Thus, your long stock vs. short call makes no money when that happens
  • Your long put continues to lose value
  • The greater the price increase, the more your put declines in value
  • To make it even worse, most rallies are accompanied by a decrease in implied volatility (IV).  If you are not yet familiar with implied volatility, then you are indeed wading in far too deeply for  a rookie trader.  Bottom line: as IV decreases, the value of your put decreases even more than it would on the rally.  It's a double whammy
  • This trade can do very poorly in a rising market.  And that's a shame because a (traditional) collar is slightly bullish and does not lose money when the market rises.  It limits gains, but does not lose money.

If the market falls significantly:

  • The call was inexpensive to begin, and it soon becomes near worthless.  It affords no additional profits on a decline
  • The position becomes essentially long LEAPS put and long stock.  You can look at this two different ways.  This combination is equivalent to a long LEAPS call (I know equivalent positions may be another topic you have not tackled, but it's very important to do so), and the call decreases in value – quickly – as the market falls.  The alternative is to recognize that the put has a delta far less than that of the stock and gains value more slowly than the stock loses value.  In either case, this loses money on a big decline
  • To offset this loss, IV tends to rise and that kicks into the picture by giving the put a bit of extra valuation.  But it will not be sufficient to prevent losing money
  • This trade does poorly in a falling market

Bottom line:  You are betting on a relatively constant stock price – and there are better alternatives for doing that.  I do not like your suggested strategy.

But I m glad you asked and hope this reply has been helpful.


7 Responses to Collars using LEAPS Puts and Front-Month Calls

  1. 02/02/2010 at 7:08 PM #

    Mark, I’ve just started learning options beyond covered calls and I recently attended a webinar that focused on protective puts offset by the selling of shorter term calls. Is your problem with the above strategy the long put and the short call or am I missing a key point? Also, which of your books would you recommend?
    PS. I’ve been immersing myself in all the options offerings on various websites and really appreciate how you layout your responses.
    Larry D.

  2. Mark Wolfinger 02/02/2010 at 7:20 PM #

    You are not missing anything.
    Today’s post goes directly to the situation you described: the married put (longer-term) coupled with the sale of near-term call options.
    I hate the married put strategy. I don’t have the vocabulary to tell you how disgusting that strategy is. And I know of at least one ‘educator’ who thinks it’s useful.
    1) A Collar is a good strategy for protecting assets. And the married put AND a call sale is a collar. However, subtleties are difficult to grasp at first, and the fact that the married put is exactly the same as owning a call option (same strike and expiration as the put) – is one of those things that beginners cannot understand at first. And the people who preach married puts don’t explain this to their students.
    Would you want to own a portfolio of only long calls? If the answer is no, then you don’t want a portfolio of married puts.
    So – the idea of buying one put and selling one call – when you own 100 shares of stock is sound. But, as I tried to explain in today’s post, there are potential problems when the put is a long-term option.
    I definitely recommend the Rookie’s Guide to Options. It contains the most material, is better written than the others and truly makes the others less valuable. If you get the book and like it (as I am sure you will), don’t be tempted to get the others.
    Thanks for the kind words. I hope you continue returning to this blog.

  3. Anthony 02/02/2010 at 8:15 PM #

    Get the book.
    Mark is not pulling your leg either it is the best “option” you can buy. For a very small piece of work it contains a large amount of very straight forward information as does this blog. What makes this blog great is seeing other questions that maybe I haven’t thought of. Speaking of questions. Mark when you say that that you like to open an IC position with a delta of around 15 do you mean +/- or only +? Also I am keeping a daily log of my total IC (2 months)position greeks with the daily change of the underlying (RUT) and the daily IV for each month I hold positions in. Is there anything or something else I should look at each morning to evaluate my positions?

  4. Mark Wolfinger 02/02/2010 at 8:48 PM #

    Thanks for the plug!
    1) When I say delta of 15, I meant to say the delta of each option I sell is near 15.
    Sometimes I accept fewer dollars and sell lower delta options, but only one strike price lower.
    2) The diary is an excellent idea. At some point you may feel you have too much data and start recording less. Or you may seek more data.
    ‘Should’ is not the word I’d use. You probably have enough data – it’s what use you can make of analyzing that data that’s important.
    If you want to collect more data – and you may be able to make good use of it when you have a sufficient quantity:
    Track the daily P/L compared with what you thought it should have been – based on the Greeks. This can give you an idea of how well the sum of the Greeks predict P/L. In other words, how well do the Greeks give you a good picture of risk.
    Do that daily, or even weekly. Don’t know if that data is any good.
    You can do that with each individual option (lots of work), each call or put spread, each iron condor, or perhaps just on your entire portfolio (obviously this is the easiest.
    BOTTOM LINE on data: Can you use it? Is it worth your time to do the work? I don’t know. Don’t undertake this unless you see some big benefit.
    Are you protected against a black swan event? The simplest way to accomplish that is is trade size that’s not too large – if something bad happens. None of your data is going to do you any good if a market surprise results in a loss of 25%, or more, of your account overnight.
    How bad can it get: That’s a data point you want to be aware of every trading day.

  5. Larry 02/02/2010 at 10:11 PM #

    Mark, thanks for the response. I just ordered the book and look forward to understanding more about collars. (seems like from what I’ve read on the blog so far it is a “favored” strategy.)
    Have to admit I’m definitely a rookie at this but here is my thought process on what I’ve learned so far.
    I realize that selling covered calls does not limit the downside but IF I don’t need the money for 5+ years, buy strong brand name stocks, AND sell calls that produce a hedge/premium of 10-20% with annual returns of 7-10%, it seems so much better than just sticking money in a mutual fund and have no control whatsoever in what happens. The insurance just doesn’t seem necessary. (I’m sure I would sing a different tune if one of them turned south a big way.)
    Thanks for your thoughts.

  6. Mark Wolfinger 02/02/2010 at 10:20 PM #

    Collars are favored for individual investors who lack any understanding of how to protect a portfolio.
    Collars, per se, are not a recommended strategy for making money – because of the strike prices that most people choose.
    Pay attention to the chapter on equivalent positions. This is not a normal offering for option rookies, but if you ‘get’ this – you will have a nice advantage when trading. The point is that you can trade a position that’s equivalent to the collar – and have a better chance to make a profit. The strategy is not better, but it’s the psychology that comes into play when selecting strike prices that makes a difference.
    Print out this reply. Use it as a bookmark, and when you finish the book, take it out again and see if you understand what I’m saying. This is neither the time nor place for an additional explanation.
    Covered calls: Yes, returns are enhanced and losses are reduced. But in a strong bull market, you will do less well than other investors In a strong bear market, you will still lose money. However, all the rest of the time this is a nice strategy, with downside risk.
    ‘Strong, brand name stocks’ are less volatile and they command smaller option premium. That makes sense. When you write the CC, you will have less risk and that comes with a reduced profit opportunity.
    Enjoy the book. Take your time because you have the rest of your life to trade.

  7. Anthony 02/03/2010 at 5:24 AM #

    Thanks Mark