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Do you have a client who has money to invest in the market but who is holding back for fear that the bear market is not over? A three-part strategy consisting of purchased Diamonds and a DJX Collar might be just what your client is looking for.

Do you have a client who has money to invest in the market but who is holding back for fear that the bear market is not over? A three-part strategy consisting of purchased Diamonds and a DJX Collar might be just what your client is looking for.

Diamonds are an exchange-traded fund that is designed to provide investment returns corresponding generally to the price and yield performance, before fees and expenses, of the Dow Jones Industrial Average as compiled by Dow Jones Corporation.

A collar is a two-part option strategy that involves the purchase of an out-of-the-money put and the sale of an out-of-the-money call. When initiated on a dollar-for-dollar basis with a position in Diamonds, a collar provides low-cost insurance and allows some upside participation. With the DJX Index at 84.00 today, and the Diamonds trading at 84.00, a DJX 80-90 Collar might be created by purchasing a March 80 Put for 4.00 and selling a March 90 Call for 4.00. The possible profit and loss outcomes of the three-part position at expiration are presented in Table 1 and Chart 1 below. The table and chart do not include transaction costs, but you should be sure to include them when discussing a real strategy with clients.

DJX options are cash-settled index options, so your client need not fear that the Diamonds will be sold if either the call is assigned or the put is exercised. Above the strike price of the short call, however, the rise in value of the short calls will offset the rise in value of the long Diamonds position. Therefore, upside profit potential is limited.

Table 1

Possible Profit and Loss Values at Expiration

Chart 1

Long Diamonds with DJX Collar

At option expiration, if the DJX Index and the Diamonds are above 90.00, then the puts will expire worthless, but the short calls will be likely be assigned. Assignment of a short DJX Call means that a cash payment is made equal to the in-the-money amount. Above the strike price, 90 in this example, the rise in value of the short calls will offset the rise in value of the long Diamonds. Therefore, in this example, profit is limited to 6.00 per Diamonds share.

If the DJX Index and the Diamonds are below 80.00 at expiration, then the short call expires worthless and the put is exercised. Exercise of a DJX Put means that a cash payment is received equal to the in-the-money amount. Below the strike price of the put, the rise in value of the put offsets the loss from the long Diamonds position. In this example, the maximum loss is 4.00 per Diamonds share, which is equal to the purchase price of 84.00 minus the strike price of the put of 80.00.

If the DJX Index is between 80.00 and 90.00 at expiration, then both options expire worthless, and the profit or loss is equal to the rise or fall of the Diamonds shares.

Motivation
A long Diamonds position with a DJX collar is appropriate for investors who are forecasting modestly rising prices and do not want to bear the full risk of a significant market decline. The distance between the purchase price of the Diamonds and the strike price of the put should be viewed as the risk that the investor is willing to assume. The strike price of the short calls should be viewed as the level above which the market is not expected to rise.

If your client wants to enter the market with limited risk and is willing to accept a limit on upside potential, then this strategy might be a good way to start the New Year.

Options involve risk and are not suitable for all investors. Prior to buying or selling an option, a person must receive a copy of Characteristics and Risks of Standardized Options. Copies of this document are available from your broker or The Options Clearing Corporation, 400 S. LaSalle Street, Chicago, IL 60605. CBOE and Chicago Board Options Exchange are registered trademarks of the Chicago Board Options Exchange, Incorporated. 2003 Chicago Board Options Exchange, Incorporated, All Rights Reserved.

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