|In this second of two articles for investors who are worried about "the frequently fearsome spring months," the focus is on the protective collar strategy. Last month's article explained how "protective puts" can be purchased to insure a stock holding just like homeowner's insurance protects a house. |
Many investors like the risk-reducing aspect of the protective put, but they are concerned about the cost. The collar is a two-part option strategy that addresses this concern. The first part of a collar is a protective put. The second part is a covered call. Covered calls are calls that are sold on a share-for-share basis against owned stock. In return for receiving a premium, the seller of a covered call assumes the obligation of selling the stock at the strike price at any time prior to the expiration date.
An example of a covered call is selling one XYZ May 80 Call when 100 shares of XYZ stock are owned. The seller of this call is obligated to sell the stock at $80 at any time prior to the May expiration date if an assignment notice is received. When used as part of a collar, the premium received from selling a covered call is used to reduce the cost of the protective put.
The advantage of a collar relative to a protective put is its lower net cost. Part or all of the entire premium received from the covered call is used to pay for the protective put. The disadvantage of a collar is the limit it places on the stock's profit potential. The covered call establishes a ceiling on how much can be made from a price rise in the stock. Graph 2 shows how, with XYZ trading at $72, selling an 80-strike call for $2 and purchasing a 70-strike put for $3 creates a collar that limits the total risk to $3 per share. It also limits profit potential to $7 per share.
How does an investor looking to reduce risk decide between a protective put and a collar? First, make sure you understand the trade-offs of each strategy, and, second, consider the market forecast that justifies each one.
Protective puts offer relatively high-cost insurance, but they do not limit profit potential if the stock price rises. Protective puts should be purchased when an investor is bullish on a stock but nervous about "something." That "something" could be an upcoming earnings report or a government announcement. Remember the old saying, "cut your losses short and let your profits run"? Protective puts allow investors to stay in the market with limited risk during times that are perceived to be high-risk.
A collar offers relatively low-cost insurance, but a limit is placed on the stock's profit potential. The covered call, remember, is an obligation to sell stock at the strike price. If an investor is unwilling to sell the stock, perhaps for tax reasons or because the long-term forecast is bullish, then the presence of the short call and the existence of the obligation to sell the stock must be addressed. Before a collar is established, then a decision must be made as to when, and at what point, the call will be repurchased to close out the obligation. It is then necessary to have the discipline to follow through on that decision.
Protective puts and collars are insurance strategies with trade-offs. The protective put, for a cost, provides protection and leaves in tact the unlimited profit potential of the stock. In contrast, the collar offers lower-cost protection but involves the obligation to sell the stock and, therefore, limits profit potential. One of these strategies may be appropriate if you think this spring could be one of those fearsome ones.
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. 2002 Chicago Board Options Exchange, Incorporated, All Rights Reserved.