As the S&P 500 continues to defy gravity and head to all-time highs, investors are facing a bit of a dilemma. The “greed” monster on one shoulder wants to stay long the market and continue to benefit from potentially higher equity prices despite the fact that this index has not had a 10% correction in several years and is potentially overdue for just such an event. The “fear” monster on the other shoulder wants to book profits now and “run for the hills” or perhaps be even more aggressive and enter bearish trades in advance of a true market turn lower. What’s an educated investor with great knowledge of options instruments likely to do? The collar trade of course.
The base of a collar trade is equity share ownership. The idea here is that over the longer course of time the price of the underlying equity will rise. During periods of consolidation when prices are somewhat stagnant or during outright bearish trends, traders can utilize options instruments around these shares to hedge risk and enhance overall return. Investors limit risk in a trade by purchasing a put and utilize premium gained in selling a short call to finance all or part of the insurance policy the put provides.
The long put gives one the right to sell shares at the strike of that option. This can substantially limit risk in equity ownership. The short call gives one the potential obligation to sell shares of the equity at the strike of that option. If that short call expires out of the money, the investor retains equity ownership while hedging downside risk. Let’s look at a specific example where an investor has longer term gains in shares of an equity and wants to use the collar trade to protect those gains against a possible downturn in the market.
An investor could have purchased shares of Facebook a year ago this time for $25/share. At the time of this writing, Facebook is trading at $65.77. That is a potential gain of $40.77/share. The investor could purchase a strike 62.50 July 2014 put for $1.49 and sell an upside 67.50 call for a credit of $2.07. The net of the two options is a credit of $58. Here are three potential outcomes for this trade at option expiration in July:
The stock finishes between $62.50 and $67.50 at July expiration. In this case, both options expire worthless. The stock is retained, and the $58 net credit is the investors to keep.
The stock finishes above the short call at $67.50. The shares would be called away for $67.50. The investor would keep the $58 credit from the options in addition to added profit on the shares due to the bullish move in Facebook from $65.77 to $67.50 representing an additional $173 above and beyond the original $40.77 per share gain.
Facebook falls below $62.50 at option expiration in July. The investor keeps the $58 net credit on the two options. As Facebook falls below $62.50, the put gains value dollar-for-dollar on the bearish move. The investor would determine if exercising his right to sell shares and take profits makes sense or take profits in the put and re-establish another collar trade going forward.
The nice thing about a collar strategy is that an investor knows the potential losses and gains right from the start. If the stock climbs higher, the profits may be curbed due to the obligation to sell via the short call, but if the stock takes a dive, the investor has protection due to the long put. Such protection might not be such a bad idea if the market corrects itself.