Managing a Collar Position in a Declining Market II

Part I

6) I note
that you had planned to sell Jul and then Aug calls in an attempt to
recover part of the premium you paid to own September puts (and stock). 
There are many who suggest that owning collars composed of long-term
puts and short term calls is a wonderful strategy.  The truth is, that
it can be profitable under two conditions:

a) You buy
those long term puts when IV is low.  If you pay up for longer-term
options and IV gets crushed, so does your position

b) The market
does not move too far in either direction.  This allows you to sell
those Jul and Aug calls as planned

I note that you made this trade
near the market highs, so perhaps you have the advantage of owning the
puts at a good price.  But the market has moved too far and you are
losing money as it slides.

7) You are correct that the Jul an Aug 121 and
122 calls are hardly worth selling.  My question is:  Why would you want
to sell those specific calls?  

I know the answer, and your situation is
common.  You bought stock at a price over 120 and you insist on selling
OTM calls against them.  The fact that the stock has declined to 108
does not deter you.  This is a blind spot for many traders.  More on
that later.  Cliff, you obviously recognize that selling calls with such
high strike prices is not going to do you any good – unless you get to
see a miraculous market rally.

You can wait for that rally, but it's not a
good way to invest.  It's possible, but you know the probability is very
low and you must find a way to make money with this position – starting

This may be difficult to accept, but if you learn to accept it
you will make more money over your career:

I believe:

I. Money that
has been lost has been lost.  Forget about it

II. Your goal
is not to break even from that losing trade

III. Your job
as a trader is to make money starting right now and into the future

IV. Your job
as risk manager is to guide your trader persona into owning positions
based on reality and not hope

V. This means you must forget the price you
paid for SPY.  It's 108 now and that's the situation you with which you
must deal.  That means writing calls with a strike over 120 is no longer

8) Here's another blind spot. You are naked long Sep 120 calls
and you fear that if you write calls with a 115 strike price the market
may head higher.  You are long.  Why fear a rally?  A rally is your

I get it.  If the market rallies too far, then you will have
locked in a loss by selling the 115 call.  No one likes to 'lock in a
loss.'  That's why I believe traders must forget their entry price and
manage a position to make money from today – not from some time in the
past when the trade was initiated.  That's ancient history.  You can
only trade for the future.

Note the blind spot:  It's okay to lose money
on a decline (that must be true because you have been trading with long
delta), but if you sell the 115 call and the market rallies, that would
be a bad thing, even though you would make money.  I hope you can see
the inconsistency there.

If you do sell that call and the market does
zoom back to 120, isn't that a good thing?  You will have earned money
from today forward.  And if you do the right thing with the puts and
roll down to a lower strike, you will prosper should the market move
back to 120.

9) Bottom line reply to your question: How
would I handle this?

I would forget my original trade.  I would
cover the Jun calls, probably at $0.05. I would sell the Sep 110/120 (or
perhaps the 112/120 or the 108/120) put spread and collect a bunch of
cash.  Then I would choose a call to sell.  Most likely it would be a
September call because I do NOT like owning
collars when the long put is long-term and the short call is near term

Better yet,
instead of working a collar, I'd close all three legs and open a
different long call spread (or short put spread).  Why bother with the
three-legged spread when you can own the equivalent two-legged spread?

You currently
have this call spread:  long Sep 120; short Jun 122 SPY call spread.

If you do what
I suggest on the puts and make a decision on the calls, you would own
the equivalent of Long Sep 110C (or other strike); short Jul 115

That's a very vega rich, long delta position.

Cliff: I do not
want to confuse you.  If you wind up with the call spread – be
absolutely certain you do not also own stock.  If you prefer to trade
the collar, then you would hold a Sep put (strike near 110) and be short
some Jul or Aug call.  Perhaps the 115 you suggested.  I have no
opinion on which call to sell.


Expiring Monthly; May 2010


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4 Responses to Managing a Collar Position in a Declining Market II

  1. AH 05/27/2010 at 9:08 AM #

    Hi Mark,
    Clearly collars reduce downside risk. As a financial planner I’m very interested in using them to help protect client portfolios. There are some issues which I’d like your views on before treading this path however.
    1) How close to the price of the underlying should the collar be established? My own research indicates that the more volatile the underlying and the further into the future the option position is established, then the ‘wider’ the collar should be to maximize long term returns. On the other hand, ‘narrower’ collars reign volatility in further but appear to really hurt long term cumulative returns. How wide should your collar be? Should it be skewed eg. 10% downside protection and 20% upside ceiling?
    2) This post is all about collar adjustments. As a planner, clients with even medium account sizes can’t afford to pay someone to continually adjust collar positions, even less so if multiple underlyings are held. Is a ‘passive’ collar strategy wise eg. 3, 6 or even 12 months out?

  2. Mark Wolfinger 05/27/2010 at 5:31 PM #

    It’s a pleasure to try to assist you. One of my oft-repeated complaints is how professional planners and advisors ignore options.
    Give me a few days to get an answer together, and I’ll publish the reply – in a full post – next week.
    Thanks for this question,

  3. JP 05/27/2010 at 11:14 PM #

    I’ve seen you mention that you think planners ignore options a couple of times. My office recently hired a CFA and he has opened a lot of eyes. We are now able to offer option overlays for clients with large concentrated positions.
    It may take some time, with such poor long term performance of most major indexes, but I think planners may start looking to options for risk management and maybe income sources.

  4. Mark Wolfinger 05/28/2010 at 7:31 AM #

    Good news. We all know that options are not for everyone, but many clients can benefit by adopting risk-reducing ideas from the options world.
    Thanks for sharing.