As the S&P 500 continues to defy gravity at the start of 2018, 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 experienced a 3% pullback in over a year! 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 returns. Investors limit risk in this trade by purchasing a put – an insurance policy – while utilizing premium gained in selling a short call to finance all or most of the cost of the put.
The long put gives one the right to sell shares at the dollar value of the strike of that option – no matter what actual value the shares might be trading at. This substantially limits 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 and keep the credit received on the short call. One great advantage of this trade is the ability to “lock in” profits that have been achieved across time. 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 Micron Technology (MU) a year ago this time for $32/share. At the time of this writing, MU is trading at $45. That’s a potential gain of $13/share. The investor could purchase an at-the-money February 2018 strike 45 put for $210 and sell an out-of-the-money April 2018 strike 50 call for a credit of $246. The net of the two options is a credit of $36 and puts the starting cost basis of this trade at $44.64/share. Here are three potential outcomes for this trade at option expiration in April:
- MU finishes between $45 and $50 at April expiration. In this case, both options expire worthless. The stock is retained and the $36 net credit is the investors to keep. Truth be told, this oversimplifies things a bit as proactive adjustments may be made to the trade including removing or spread trading the put option for additional profitability in the trade as well. The shares are still owned and can be placed in a collar trade again at any point in time.
- The stock finishes above the short call at $50. The shares would be called away for $50. The investor would keep the $36 credit from the options in addition to added profit on the shares due to the bullish move in MU from $45 to $50 representing an additional $5.36 per share profit above and beyond the original $13 per share gain.
- MU falls below $45 at option expiration in February. The investor keeps the $58 net credit on the two options. As MU falls below $45, 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 option 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. As in the MU example, it is a great way to lock in profits ahead of potential downside volatility. If the stock climbs higher, you get to participate in the upside while protecting those hard-earned profits in the case of bearishness. Such protection might not be such a bad idea in a market that on many metrics is extended and due for a course of higher volatility to come.