Don't Forget Your Protective Collar

By George D. Lambert AAA

When the markets start swinging wildly, investors scurry for safety. They might head for indexed annuities, principal protection funds or other investments that offer some type of downside defense, but even though these investments have many applications, they might not be suitable, because they frequently require a long-term commitment.

A protective collar is a strategy that could provide short-term downside protection. It offers a way to protect against losses, allows you to make money when the market goes up and sometimes is accomplished at little or no cost.

Two-Part Strategy
There are two parts to implementing a protective collar: protection against losses and finding financing.

Protect Against Loss
First, you want to protect your profits. You do this by purchasing a put option contract on your stock. A put option gives you the right, but not the obligation, to sell (to put) your stock during the contract's term at the specified strike price - no matter how low the market price may have fallen. This lets you establish a minimum sales price for your stock during the put's term.
SEE: Introduction to Put Writing and Prices Plunging? Buy A Put!

For example, suppose you own 100 shares of Digit Computer that currently trades at $110 per share. Because you bought the stock at $25 per share, you have an $8,500 gain ($11,000 - $2,500).

A Digit Computer put option with a strike price of $100 that lasts 12 months would lock in a $7,500 profit ($10,000 - $2,500), regardless of how much the shares fell during that time. So far, so good. You've set a floor on how low your stock can go, but, this insurance comes with a price.

Now, let's assume you have a 12-month put option, with a strike price of $100, which cost $11 per option. This means your outlay will be $1,100 ($11 x 100 shares). Because an out-of-the-money put option typically is purchased, you will have to figure out how to come up with the $1,100 to pay for your put contract.

The Funding
The second part of the collar strategy is to sell (or write) a call option on Digit. When you write a call contract, you are giving the buyer the right, but not the obligation, to purchase (or call) your shares during the contract's term at the strike price.

Assume that a 12-month call contract with a strike price of $140 sells for $12 a share. This will get you $1,200 ($12 x 100 shares). In this case, you actually netted $100 ($1,200 - $1,100) on the two transactions.

SEE: Options Basics Tutorial

In this example, the protective collar gave you a maximum downside risk of 10% ($100 put option strike price / $110 current market value) and an upside potential of 27% ($140 call option strike price / $110 current market value).

As the Markets Turn
Markets are volatile; they go down, up and sideways. Each will produce a different outcome on your costless collar strategy. So, let's go to back to the Digit stock and see what could happen.

Stock Goes Down
What if Digit plummets to $50? You could exercise the put and sell it for the $100 strike price. You'd end up with a $7,500 gain ($10,000 - $2,500). You could also sell the put option for its market value (it most likely went up to a similar value during this time) and keep your stock. The call option you sold will expire unexercised because your call buyer isn't going to pay you $140 a share for your stock when the prevailing market price for it is lower.

Overall, you would have earned a small net profit from the sale of the call and the purchase of the put (+$100). This would make your total profit $7,600.

SEE: Forecasting Market Direction with Put/Call Ratios

Stock Goes Up
Your stock shoots up to $160. As a result, your put will expire worthless. What's more, the buyer of the call option you sold will call your stock, and you'll have to sell it for $140 a share.

You'll miss out on the profit above $140, but you'll still get to keep the additional $3,000 in gains ($140 - $110 = $30 x 100 shares) in addition to the original $8,500 and the $100 from the net option transaction for a total profit of $11,600.

Stock Doesn't Move
Over the next 12 months, the stock never goes up or down more than $2. By the end of the contract's term, it's exactly where it started - at $110.

Your put contract is worthless because the stock didn't get to the $100 strike price and your call contract's buyer won't buy your stock for $140 because they can get it on the open market for $110. Therefore, the call expires without being exercised, and you keep your stock and your $100 from the options transaction.

Tax Savings
A collar can be an effective way to protect the value of your investment at possibly a zero net cost to you. However, it also has some other points that could save you, or your heirs, tax dollars.

For example, what if you own a stock that has risen significantly since you bought it? Maybe you think it has more upside potential, but you're concerned about the rest of the market pulling it down.

One choice is to sell the stock and buy it back when the market stabilizes. You might even be able to get it for less than its current market value and pocket a few additional bucks. The problem is, if you sell, you'll have to pay capital gains tax on your profit.

By using the collar strategy, you'll be able to hedge against a market downturn without triggering a taxable event. Of course, if you're forced to sell your stock to the call holder or you decide to sell to the put holder, you'll have taxes to pay on the profit.

You could possibly help your beneficiaries, too. As long as you don't sell your stock, they'll be able to take advantage of the step-up in basis when they inherit the stock from you.

SEE: A Long-Term Mindset Meets Dreaded Capital-Gains Tax

The Bottom Line
Suppose your stock represents a large portion of your net worth and you realize that your portfolio should be more diversified. Or perhaps you need cash, but you don't want to sell right now, or you can't, because the stock is restricted.

You could use the stock as collateral for a loan. Depending on the liquidity and strength of the stock, your banker might loan you 5-70% of its market value. If you set up a protective collar on your stock, it's possible that the lender will loan you more.

Then you could take the cash and reduce your risk by investing in other securities without selling your stock.

Note: The hypothetical example shown above does not include the cost of commissions on the stock or options trades, which could take a chunk of your profit.

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