Tag Archives | collars

The Stretched Collar, Again

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

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

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 discounts for Inter Commodity Spreads

I believe that the Nasdaq will outperform 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.

I need a bit of clarification. I assume you mean that after selling the calls every month for for six months, you will collect more than the cost of the put. Or, are you telling me that you will collect that much the first month?

Does the basic risk as you explained (the very expensive put loses so much money, that it kills my whole play) apply to this situation too?

If the market drops, 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

***

Hello Amir,

When replying to reader questions, I don’t know anything about the trader. Sometimes I receive very sophisticated questions from someone who doesn’t understand what he is asking. At other times, I must be careful not to provide a rookie answer to a more sophisticated trader. It makes it difficult.

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? I ask because you are not using an ordinary strategy.

This question is difficult to answer. Many factors are in play. If you are a rookie, I would tell you that this is too complex and that you should get your experience with a simpler approach. On the other hand, if you are an experienced trader with experience trading this setup, then I’d be encouraging you to continue.

***

Almost anything ‘can’ work

The question is whether this (or any other) play has an appealing (to you) risk/reward profile.

I’ll offer comments. Use anything that’s appropriate and discard any ideas that don’t apply to you.

This position feels delta short and would not do well in a rally. The collar trade that you appear to be emulating performs much better (than this trade) when the market rallies.

1) I assume you understand the vega risk of this position. You own lots of vega from that long-term put. If the market rallies you would be in trouble. Let’s look more closely.

a) This position is naked short 1 ES contract. Yes, it appears that you own 2 NQ minis, but by writing covered calls, the upside is limited. There is nothing worse than being naked short calls (or stock or futures) in a big rally.

b) You are short 2 NQ ITM puts (equivalent to the two covered calls). Those will make good money on the upside, but the profit potential is limited. It is not enough to offset the naked ES short – on a big up move.

c) Owning an OTM, longer-term put would not only lose money on that rally, but the likely IV crush translates into an even larger loss. True you sold two shorter term options (you may look at them as either the covered call, or the naked put) – but that single, long-term put option has more vega that these two options combined. That is not good on the upside (and it’s not so good on the downside either)

The upside is risky

I understand that the delta of this position depends on which specific options that you traded, but this feels short. If it is neutral, it would become short quickly due to negative gamma.

2) What I do not like about that play is that you do not know where the market will be when it’s time to sell the next round of calls. I know that it should not matter because once expiration has passed, wherever the market is as that time, you are long 2 NQ and short 1 ES and that you can afford to write to call options. But that put option makes a big difference.

What if the market moved higher, that put is now farther OTM and offers less protection. In fact, it may soon become nothing more than disaster insurance.

That’s not a realistic collar – because the put is supposed to provide good protection because it is not far OTM. In your trade, that long put is a play on volatility. You are depending on a big IV increase to protect the value of the portfolio. Most collar buyers rely on gamma – or the fact that their long options gain delta very quickly when they move ITM.

It’s acceptable to trade vega for gamma, but it is far from riskless. I get the fact that theta is on your side and everyone loves positive theta. however, its buddy, negative gamma is where the risk lies. This position requires careful handling and adjusting if the market continues to move higher.

How far OTM is too far OTM for you? At some point you may be forced to roll that put to a higher strike? When would you make this trade? How much cash are you willing to invest? Whatever you decide, write that sum into your trade plan so you can remember to do it when the time comes.

It’s difficult to gauge such costs when you would must estimate a market level and an IV level to estimate the cost.

3) Yes: In this play the 6-month put loss could make this whole play a loser. As already mentioned, you have upside risk outside that put.

Use ‘what if’ software to examine the value of the portfolio at different prices, IV, and dates. There is no need to make this into a guessing game. You can gauge risk/reward and see where your risk lies much better if you take a look at some possibilities.

4) The downside appears to be better.

a) 2 NQ vs 1 ES ought to be a reasonable hedge – when we look at the $20 per point vs. $50 per point comparison. If NQ does not decline by more than 50% as much as ES, you are in good shape. Please remember that NQ is far more volatile than ES, and I don’t know whether 2:1 is the right, market neutral hedge. If you get the hedge right, then you will prosper if NQ outperforms.

b) You own a naked put option. That’s good in a decline.

c) You are long vega and that should be good, but not always. When IV explodes during a violent market, it’s the near-term options that explode the most. In other words, the big IV increase provides a good bonus for the price of your long put, but it’s possible – depending on time to expiration and just how much the IV jump in the front-month options exceeds that of the longer-term option – that you can lose money from the IV surge.

I recognize that you are short front month calls, and not puts, but they may not decrease in value (as the market falls) by enough to do contribute to the portfolio value. Against that naked put, you own 2 NQ vs being short 1 ES, and this is a bearish play.

One more point. This is a convoluted trade and I may not be correct in my analysis. If you want a collar, I think you should trade a collar equivalent (sell a put spread).

I am not comfortable enough with my analysis to give you advice. It just feels to be a bearish trade. You must run the risk graphs, and your broker may offer suitable software. Ask. The computer will give you a much better picture of risk than I can.

If you do that, I’d like to see one of those risk graphs.

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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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More on Financial Planners and Collars

Mark,

Great blog. As an advisor in a similar position to AH, I find this
blog extremely helpful when it comes to developing various options
platforms. This post was especially helpful as collars are the main
risk management strategy we hope to utilize.

Your answers have pretty
much confirmed my original ideas; however, I have the following
questions:

1. We have diversified portfolios that blend passive ETFs and different
active managers. As such, I was thinking that portfolio Betas
(relative to the S&P 500) should be used to determine strike prices
and the amount of options purchased/sold on the S&P index. For
instance, if a client has a Beta of .50 and wishes to lose no more than
15% a strike 30% below the current S&P level could be used before
the client would reach that 15% waterline.

Likewise, only half of the
portfolio would have to be used when determining how many S&P index
options to purchase. Ignoring the problems with Beta (I can't think of a
better way to hedge the portfolio), is that above assumption generally
correct?


2. Given the high cost of S&P index puts relative to calls and the
goal of collar (at least in our case) of downside protection, what is
the danger in buying puts 12 months out and rolling calls? The shorter
calls should allow to take greater advantage of positive Theta and
looking roughly at the math may turn out to cover the cost of the puts
(I realize there is no way to calculate this), while the longer dated
put would provide the desired hedge.

3. Does is make sense to actively manage the collar or just let the
strategy run its course? While there certainly are situations when one
might be more beneficial, is there a broad explanation? I was thinking
of selling the put if it is in the money and using the proceeds to by an
at the money put or rolling up calls on the upside.

4. Similar to the question above, does it make more sense to close the
position prior to expiration or let the options become exercised, if
possible.
Given the length of the questions, I understand if you can't get to
this. Regardless, thanks again for the very insightful blog and I look
forward to learning more from you in the future.

ZA

***

Thanks ZA,

Glad to hear this blog has been helpful.

1) If I understand correctly, you don't want to collar the specific positions you own, but prefer to buy puts and sell calls on SPX.  I'll assume that is correct.

Nothing wrong with doing that.  However, as far as your broker is concerned, this involves the sale of naked calls on the SPX.  Yes, you are covered for risk, but many brokers will not allow the sale of naked calls.  Period.  Those that do require large margin.

Do not allow this to be a limiting factor for you.  You can find a broker who will accommodate this strategy.  Of course, some clients may not want to change brokers, and you may not be able to adopt this methodology for them.

2) We tend not to use beta in the options world, and use the volatility of each ETF on its own. By owning funds of active managers (I hate the fees charged; I hope the returns justify those fees), you don't have such a volatility number and would have to calculate it – or use beta as being 'good enough.'

3) If you have a .50 beta portfolio, you are assuming a 15% move when SPX moves 30%.  If beta holds true to form, that is a reasonable expectation.  Just be aware that sometimes specific types of investments can become more (or less) volatile than one would expect and beta can change.

If you accept this limitation, using beta ought to be okay.  I'd like to avoid beta calculations, but it's also time consuming and costly (broker commissions) for your clients when you collar each investment individually. 

4) When choosing a strike price [30% OTM (out of the money) in your example], don't ignore the cost of the put when estimating the maximum loss.  Unless you plan to offset the cost of the puts by selling calls at approximately the same dollar amount.

That is a good way to choose which calls to sell – but it's a call that expires in the same month.

5) You ask about the risk of owning long term puts and selling monthly calls.

The long dated put does not provide the hedge you think it does. 

I recently posed a lengthy (2 part) description of that risk.  It is MUCH LARGER than expected.  And oddly, the downside risk is just as large as the upside risk.  This is NOT a good idea for your clients.

It may be a good idea for anyone who wants to 'play volatility' – but a customer should not be paying for trading advice from a planner.  He/she should be paying for planning advice.  Clients who are interested in setting a maximum risk level should NOT be doing as you suggest.

Yes, you can earn lots of extra dollars.  But this idea can lose bunches of money and is just not the right strategy for people who they to limit losses.  Please read that post.

Even if you decide to take this risk, you do NOT want to buy long term options when IV is high. You pay a lot for those puts and may get very poor prices for the shorter-term options. 

6) I do not believe it is correct to hedge half the portfolio. 

Assume a client has 100k, and you buy options that are 30% OTM.  If those are eventually exercised, the assumption is that a .50 beta portfolio would lose only 15k and not 30k.  That is he maximum.  You cannot buy fewer puts.

NOTE: SPX options settle in cash, so if exercised, you get some cash to offset losses beyond that (estimated) 15% loss.

7) In general you do not want to actively manage the collar.

But, that does not mean you should not take advantage of certain situations.  If for example, the market tanks and Iv moves higher, that may be a good time to do as you suggest.  Roll the put to a less expensive one, taking in cash and improving the upside.  Do keep in mind that this makes the downside worse – so the 15% maximum may be exceeded.  I'm not saying not to do it.  I am telling you to consider the new potential loss.  When markets are falling is when clients will not want to give up protection. 

It's a difficult decision.  You can earn a lot of extra dollars if you get lucky and make such an adjustment near the bottom.  That's why it's important to recognize just how much you are making the downside when making this trade.

The idea is to take out some cash – it's safer not to grab the maximum amount of cash from an adjustment.

You may also want to roll the call, but be careful not to roll too far.  That could hurt the upside.  Be certain the call still has a higher strike that the new put you own.

8)  If using SPX options, it doesn't matter if you exercise them.  These are settled in cash.  And as a reminder, these options are European style and cannot be exercised prior to expiration.

However, if you do trade ETF options for some clients, then it gets messy to exercise options and take a position in the underlying.  I would exit and roll as expiration day gets near to eliminate this inconvenience.

If you are assigned on calls, same situation.  No real problem, but it's better to avoid taking a position when you don't have to.  Just roll prior to expiration.  Pay attention to ex dividend date when trading SPY.

One more thing:  I know that many
investors find options complicated, but that is due to a lack of
understanding.  If you have clients who want to understand what you are
doing for them, please recommend The Rookie's Guide to Options.

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Free e-book: Introduction to Options: The Basic Concepts

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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
today.

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
viable

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
friend.

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
call.

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.

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Managing a Collar Position in a Declining Market

I received an important question from a long-time reader.  There are several important lessons embedded within this question:

Mark,

I am long SPY at about 121.50 and protected by long September 120 puts. I sold June 122 calls against the position to defray the cost of the long puts (which, I believe, is something you advocate). I plan on selling additional calls in July and August to further reduce the cost. However, as SPY drops, the premium on the 122 and 121 calls is diminishing to almost useless levels. If I were to sell a lower call with a higher premium, like a 115 or thereabout, I risk a reversal in the market.

How do you suggest handling this set of circumstances?

Cliff

***

Thanks for this very interesting question.  This discussion allows me to cover more than one of my favorite 'philosophy of trading' scenarios.

1) You own a SPY Sep DITM put (SPY is currently 108) plus stock.  You don't state how many puts you own, so I am going to assume you own one put for each 100 shares.

That means your true (equivalent position) is long SPY Sep 120 calls. 

2) Obviously this is a position that is delta long and does not fare well when SPY declines.

3) Here's
the very first thing you should do. ADDENDUM: Tuesday morning.  Markets are even lower.  Rolling the put is still right, but it's even more difficult to choose which call to write now.  IV will give you a better premium, but which strike?  You do not need to hold a $15 put
to protect stock.  Sell that expensive put and replace it with another
put.

If you prefer to remain long vega, buy a Sep put with a lower
strike price.  How much lower?  I cannot tell you, but you want to get
some cash out of this position.  There are two ways to do that.  The
first is to roll down the put, as suggested here.
Or
use some of that cash to buy an extra put or two
.
  The second is to sell
a new call option.

Note that if you sell the 120 puts and buy 110
puts, then your position will be long the (synthetic) Sep 110 calls. 
You will no longer fear a rally.

4) You are short Jun 122 calls.  These may have been ATM calls when you made the trade, but they have been offering almost no downside protection for the last several points that SPY declined.  

For all intents and purposes you are naked long Sep 120 calls.

5) I am in favor of selling calls when you own stock and puts, but when the put is 12 points ITM and the call is trading near zero, that's not a hedge and is not something I advocate.

Nor do I like the idea of owning long-term puts and writing short-term calls when trading collars.  These can be spectacularly successful, but are far too risky for me.  They may be okay for you – as long as you understand the extra risk inherent in these stretched collars.

There are almost 4 weeks remaining until the Jun options expire.  The Jun 122 calls last traded at 4 cents.  I can understand not wanting to waste money, but there is absolutely nothing to gain by waiting almost 4 weeks for these options to expire.  You are naked long the Sep 120 calls and unless you want to own that position, you should be doing something.  In fact, it's rather late.  But better late than never. Bid something to buy those options.  That frees you to sell other call options and complete the collar.

to be continued


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