Putting Collars To Work

In finance, the term "collar" usually refers to a risk management strategy called a "protective collar"; however, the use of collars for other situations is less publicized. With a little effort and information, traders can use the collar concept to manage risk and, in some cases, increase returns. This article will compare protective and bullish collar strategies in terms of how they can help investors manage risk and increase returns. (To learn the basics to collars, see Don't Forget Your Protective Collar.)

How Protective Collars Work
This strategy is often used to hedge against risk of loss on a long stock position or an entire equity portfolio via the use of index options. It can also be used to hedge interest rate movement by both borrowers and lenders by using caps and floors.

Protective collars are considered a bearish to neutral strategy. The loss in a protective collar is limited, as is the upside. Should the collared position increase above the strike price of the short call, the investor will lose the upside potential - or suffer an opportunity cost. (To learn more about these collar basics, see our Options Basics tutorial.)

Equity Collars
An equity collar is created by selling an equal number of call options and buying the same number of put options on a long stock position. The premium from the sale of the call is applied toward the put purchase, thus reducing the overall premium paid for the position. Market pundits recommend this strategy when there is neutrality following a period of increasing share price; it is designed to protect profits rather than increase returns.

For example, let's say that Jack purchased 100 shares of Microsoft (Nasdaq:MSFT) some time ago for $22 per share. Let's also assume that it is July and that MSFT is currently trading at $30. In consideration of recent market volatility, Jack is uncertain about the future direction of MSFT shares, so we can say that Jack is neutral to bearish. If he were truly bearish, he would sell his shares to protect his $8/share profit, but he is not sure, so he is going to hang in there, and enter into a collar to hedge his position.

The mechanics of this strategy would be for Jack to purchase one out-of-the-money put contract and sell one out-of-the-money call contract, as each option represents 100 shares of the underlying stock. Jack feels that once November is over, there will be less uncertainty in the market, and he would like to collar his position at least through November. Jack finds that MSFT presently has options trading in the months of October and January. (To learn more about trading cycles according to specific months, see Stock Option Expiration Cycles.)

To accomplish his objective, he decides upon a January option collar. Jack finds that the January 27.50 strike put option is trading at 2.95 and the January 35 strike call option is trading at 2.00. Jack's transaction is:

• Buy to open 1 January 27.5 put option at a cost of $295 (premium of $2.95 * 100 shares)
• Sell to open 1 January 35 call option for $200 ( premium of $2.00 * 100 shares)
• Jack is out of pocket (or has a net debit) of $95 (-$295+$200 = -$95)

It's difficult to pinpoint Jack's exact maximum profit and/or loss, as there are many things that could transpire.

Let's look at the three possible outcomes for Jack once January arrives:

1. MSFT is trading at $50 per share: As Jack is short the January 35 call, it is most likely that his shares were called at $35. With the shares currently trading at 50, he has lost $15 per share profit, plus future capital gains and his out-of pocket cost on the collar. We can say that this is a bad situation for Jack's pocket and an example of an opportunity cost. However, we cannot forget that Jack purchased his original shares at 22, and they were called (sold) at 35, which gives him a capital gain of $13 per share and any dividends he earned along the way minus his out-of-pocket costs on the collar. (Keep reading about capital gains in Capital Gains Tax Cuts For Middle Income Investors.)
   
   
2. MSFT is trading at $30 per share. In this scenario, neither the put nor the call is in the money, so Jack is back where he was in July minus his out-of-pocket costs for the collar.
   
   
3. MSFT is trading at $10 per share. Jack's long put has increased in value by at least $17.50 per share (the intrinsic value). He can sell his put and pocket the profit to offset what he has lost on the value of his MSFT shares. He can also actually put the MSFT shares to the put writer and receive $27.50 per share for stock that is currently trading in the market for $10. Jack's strategy would depend on how he feels about the direction of MSFT shares. If he is bullish, he might want to collect his put option profit, hold onto the shares, and wait for MSFT to come back up. If he is bearish, he might want to put the shares to the put writer, take the money, and run.

As opposed to collaring positions individually, some investors look to index options to protect an entire portfolio. When using index options to hedge a portfolio, the numbers work a bit differently, but the concept is the same. You are buying the put to protect profits and selling the call to offset the cost of the put.

Not so commonly discussed are collars designed to manage the type of interest rate exposure present in adjustable-rate mortgages (ARMs). This situation involves two groups with opposing risks. The lender runs the risk of interest rates declining and causing a drop in profits. The borrower runs the risk of interest rates increasing, which will increase his or her loan payments.

OTC derivative instruments, which resemble calls and puts, are referred to as caps and floors. Interest rate caps are contracts that set an upper limit on the interest a borrower would pay on a floating rate loan. Interest rate floors are similar to caps in way that puts compare to calls: they protect the holder from declines in interest rates. End users can trade floors and caps to construct a protective collar, which similar to what Jack did to protect his investment in MSFT.

The Bullish Collar at Work
The options trading world recognizes a number of option strategies. The bullish collar in some ways falls in with these, but also deserves mention in the collars category. The bullish collar involves the simultaneous purchase of an out-of-the-money call option and the sale of an out-of-the-money put option. This is an appropriate strategy when one expects a moderately lower stock price and wishes to purchase the shares at that lower price. Being long the call protects a trader from missing out on an unexpected increase in the stock price, with the sale of the put offsetting the cost of the call and possibly facilitating a purchase at the desired lower price.

If Jack is generally bullish on Yahoo! (Nasdaq:YHOO) shares, which are trading at $20, but thinks the price is a little high, he might enter into a bullish collar by buying the January 27.50 call at 0.73 and selling the January 15 put at 1.04. In this case, he would enjoy an initial net credit of 0.31.

The possible outcomes at expiration would be:

1. YHOO above 27.50 at expiration: Jack would exercise his call (or sell the call for a profit, if he did not want to take delivery of the actual shares) and his put would expire worthless.
2. YHOO below 15.00 at expiration: Jack's short put would be assigned and the call would expire worthless. He would be required to purchase the YHOO shares at $15, so his cost per share would actually be 15-0.31 or $14.69.
3. YHOO between 15.00 and 27.50 at expiration: Both of Jack's options would expire worthless. He would get to keep the small profit he made when he entered into the collar.

Conclusion
In summary, these strategies are only two of many that fall under the heading of collars. As financial creativity increases, so do collar strategies. Other types of collar strategies do exist and they vary in difficulty, but the two strategies presented here are a good starting point for any trader who is thinking of diving into the world of collar strategies.