Collars: Why it’s not a Good Idea to use LEAPS Calls as a Stock Replacement

Hi Mark,

I am interested in trading collars, but instead of buying stock I
want to buy a long-term call, to save money and increase the ROI. 

Do you ever do your collars this way?


It seems like a superior approach to collars, and I was wondering why I
am having such a hard time finding a thorough discussion of this
approach?
 
Do you teach it?
 
Thanks,


Ed

***

Good question, Ed.

I don't teach this specific strategy, have never used it, and want to be certain you understand its limitations.  You don't need me to teach you how to do this.  If you decide to use these 'almost collars' you will have no difficulty in setting up the trades.

1) I agree that the trade you suggest seems to be superior.  But appearances can be deceiving.

2) You can probably find much to
read on the topic of using LEAPS as a stock replacement when writing covered
calls
.  That should be sufficient for you to gain an understanding of your suggested strategy because all you have to do is buy puts to complete the collar.

But, I do issue this warning:  Those who write about using LEAPS as a stock replacement never mention the disadvantages (risks) of using LEAPS this way.  Are these writers unaware of the risks – or are they protecting a vested interest in getting readers to adopt this method and pay for specific trade recommendations?

3) The delta of a LEAPS call is less than 100, and when the stock rallies, the LEAPS – even when reasonably deep in the
money – does not move point for point with the stock.  That may not
seem to be a problem, but if the call you sold (wrote) moves into the money and
the stock continues to rise, owning the LEAPS option instead of stock does turn into trouble.   Especially when expiration nears. 

The call you sold increases in value faster than your LEAPS call, because it has a higher delta – a delta that rapidly moves towards 100.  Thus, you begin to
lose money as the stock rises – and it's possible to lose enough money to turn the trade into a loser.  And don't ignore the fact that you are losing extra cash because the value of your put option is decreasing.



This never happens with a 'real' covered call or collar.  There is never an upside loss with the slightly bullish collar (or even more bullish covered call). 

You do gain the benefits mentioned, but in return you add upside risk.  Is that a good trade-off for you?

***

If you have experience trading options,
IMHO it's unnecessary to trade the true collar – unless you already own stock
and there are tax considerations.


It's more convenient to trade an equivalent position, the put spread, instead.  Why?

Commissions are reduced (2 legs instead of three) and the position is easy to follow and/or adjust.

[If you are not 100% certain that a collar is equivalent (same profit,
loss, risk, reward) to the collar, then continue to trade collars.  It's important that you be comfortable with positions in your portfolio.]


To sell the put spread:  Look at the collar.  Buy the same put as the
collar and sell the put with the same strike and expiration as the call.

You mention ROI (return on investment):  The margin on the put spread is small.  But I must issue a big warning;  DO NOT TRADE TOO MANY OF THESE.
I assure you that many traders, thinking 'how risky can it be to sell a
bunch of these spreads when the margin is only $500?' (for a 5-point
spread) sell too many and get burned.

If you want to trade 3 collars, sell ONLY 3 put spreads.  This is very important, and too often ignored.


If selling put spreads doesn't appeal, then you may also buy call spreads.  These
positions are all equivalent to each other.  Again, looking at the collar you plan to trade, sell the same call as the collar, and buy the call with the same strike and
expiration as the put purchased for the collar.

I prefer to avoid using LEAPS, but if you understand the limitations, then you have a choice to make.  If ROI drives you, consider selling the appropriate put spread.

***

Clarification:

If this is your collar:


Buy 100 shares RGTO

Buy one RGTO Jan 60 put

Sell one RGTO Jan 70 call


Then sell one RGTO Jan 60/70 P spread instead 

Or buy one RGTO Jan 60/70 C spread.

537


10 Responses to Collars: Why it’s not a Good Idea to use LEAPS Calls as a Stock Replacement

  1. Donald W. 12/02/2009 at 8:18 AM #

    Mark,
    I like to debate on a Yahoo coveredcalls board in order to sharpen my mind and like to know if I can quote(cut-and-paste) some of your writtings…not your book but what is on the blog.

  2. Mark Wolfinger 12/02/2009 at 9:12 AM #

    Yes you may do that. Thanks for asking.
    Please provide a link to the original. (That’s the ‘permalink’ at the bottom of each post.

  3. Brad 12/02/2009 at 11:48 AM #

    Hi again Mark,
    It seems that you prefer to trade (or at least illustrate) the Russell 2000 index over other indexes for your Iron Condor trades. I know that you like to use a cash-settled European-style exercise index options, but what process would you use to select a preferred underlying? Why not use S&P 500 or Nasdaq 100 or some other equity index?
    I assume that options on all of the highly liquid indexes would be fairly priced (per standard pricing methods – black-scholes) so would it really matter which index to use as the underlying so long as you are creating equivalent risk/reward strategies among the indexes? I know position sizing is a factor to take into account, as options on futures are a larger minimum position than ETFs, but I was looking for a reason beyond that simple factor.
    Thanks.

  4. Mark Wolfinger 12/02/2009 at 12:06 PM #

    Brad,
    I prefer SPX. But I was unable to get decent fills and trade reports required up to 90 seconds. Those conditions were intolerable. I have not tried to trade SPX options for a long time.
    If your broker does better, SPX may be for you.
    Here’s something even simpler:
    Process used to choose an index? Which type of stocks do you want to hold in your portfolio? The large caps (SPX) are less volatile than the small caps (RUT), and that’s a perfectly good reason to trade them. I would if I could.
    The second crucial factor is ease of trading. How good are the fills? Do the market makers bend and give you fills that are acceptable?
    Sizing is very important for managing risk, but comes after you choose the underlying asset(s) to trade.

  5. Brad 12/02/2009 at 12:18 PM #

    In regards to the volatility of the underlying:
    “The large caps (SPX) are less volatile than the small caps (RUT), and that a perfectly good reason to trade them.”
    Wouldn’t the option prices reflect either a larger or lesser volatility of the underlying? RUT options should intrinsically be more expensive than SPX options because of the volatility gap – wouldn’t this increase in credit received create an equivalent risk position among the two indexes?
    If the above holds true then it come down to the order fills and market makers. Wouldn’t the bulk of this decision stem from what broker you are using? I would guess that most discount option brokers would have the same quality of lackluster fills while more expensive brokers would be able to achieve better fills at an increased commission though.
    I’m not trying to discount your argument, but trying to understand why one would trade one underlying over another more fully.

  6. Mark Wolfinger 12/02/2009 at 2:44 PM #

    Brad,
    If you trade stocks, you have a choice. Do you select a stock randomly,or do you have a reason?
    It’s the same for an index. You choose your underlying based on whether you want to take a bullish, bearish, or neutral stance on that underlying.
    1) Yes, Brad, the less volatile SPX options trade with a lower implied volatility and that means smaller premiums for similar spreads. Less premium, less risk of loss. That’s the world of investing.
    2) It always comes down to fills. If you wanted to trade a $50 stock in which the bid ask spread is always at least 50 cents wide and the market makers were never more than 10 x 10, you would (should) give up on trading the options of that stock.
    3)You are drawing incorrect conclusions from my statements. My broker provides an outstanding quality of fills for electronic trading. They have the track record that allows them to advertise their good fills.
    The problem – again – the last time I tried to trade these options – was that there was no electronic trading and that all orders are filled by brokers. I no longer care enough to find out whether I get can get better trade execution today. In theory I could switch to SPX, in practice I don’t want to change from RUT.
    If you can get electronic fills in microseconds, then my problems don’t concern you. And it’s true that getting good fills is the name of the game, but please do not believe that the full service brokers are better than the discounters in this regard.
    The ‘lackluster’ fills come from firms that direct their orders for a single exchange because that exchange provides the highest payment for order flow (a legal bribe).
    4) As to your last point, I don’t know how to reply. I can tell you why I choose one over another. I cannot speak for anyone else.
    These index options trade so many contracts in a given day, that if you trade liquid options, you should have no problem with fills. I don’t trade these options. I prefer OTM, non-front-month options, and these see fewer orders and less trading volume.

  7. Brad 12/02/2009 at 4:24 PM #

    Thanks Mark. Can you recommend any Brokers that you have worked with that offer good execution at a good price? Especially brokers where the account minimums or volume discounts don’t come into play so much as I think most of the readers here don’t trade in the millions (maybe they do, but I sure don’t) actively.
    I’m currently trying out the Think or Swim platform and it has some neat bells and whistles. Not sure about execution yet though.

  8. Mark Wolfinger 12/02/2009 at 5:36 PM #

    I use Interactive Brokers. Commissions 70 cents. No exercise or assignment fee. No ‘per ticket’ charge.
    They do not provide hand-holding customer service, and they will let you trade anything…If you can meet the margin requirement.
    TOS has net stuff with great analytics. But, there’s a price to pay to trade with them.

  9. greg 12/04/2009 at 8:51 PM #

    Mark – you suggest not trading too many collars. However, in using your insurance method of 2nd month OTM put credit spreads and front month insurance, I have noticed that the profit/loss charts are similiar to the ones in “Rookies” in the chapter on insurance. The insurance works! If you have a number of spread contracts and use insurance to cover them and are willing to risk a pre-estimated loss while expecting a profit would you still recommend only having a few contracts?
    Thanks

  10. Mark Wolfinger 12/04/2009 at 9:28 PM #

    Good point.
    Full reply tomorrow morning, as a regular post.
    The problem with buying insurance for collars is that profits are usually very limited and you must be certain that you don’t spend so much on insurance that you no longer have room to earn any money.