Most individual investors don't think much about the possibility of hedging within their stock portfolio. Instead, most simply buy shares of stock and hope for the best. Yet the fact remains that by using options, an investor has a great deal of flexibility in terms of managing risk on a position by position and portfolio-wide basis. One such strategy is known as the "long collar" and it can be extremely useful. This unique strategy allows a stock trader to drastically minimize the risk associated with a particular stock position.
What is a Long Collar?
A long collar (for simplicity's sake, we will refer to it simply as a "collar") involves buying or holding shares of a given stock, selling a call option against that stock and simultaneously buying a put option on that same stock. The net effect of a typical collar is a position with a defined maximum profit potential and a defined maximum risk. To enter a collar in order to hedge an existing stock position, a trader would first sell one call option with a higher strike price for every 100 shares of stock held and simultaneously buy one put option (typically one with a strike price lower than that of the call option that was sold) for every 100 shares of stock held. (Learn more about buying and selling options, in our Options Basics Tutorial.)
Once this trade has been executed, the trader has a locked in profit/loss tradeoff up until the time of option expiration. Figure 1 displays the particulars for a long collar trade using Electronic Arts (Nasdaq:ERTS).
|Figure 1: ERTS Long Collar Trade|
|Source: Optionetics ProfitSource|
Figure 2 displays the risk curves for the trade displayed in Figure 1.
|Figure 2: Risk Curves for ERTS Long Collar|
|Source: Optionetics Platinum|
Given that there are 28 days left until option expiration, the key things to note in Figure 1 are:
-The trade has a reward-to-risk ratio of 2.67-to-1.
-The very worst loss that the trader can suffer through option expiration is just $68.
When to Use a Collar
There are many instances when a collar might make sense for an investor or trader. The simplest example would be ahead of a significant announcement, for example an earnings announcement, that the trader feels could adversely impact the price of the stock. So if you are concerned that there may be a negative announcement effect, but for one reason or another you do not wish to sell the stock, a collar on the existing stock position will effectively eliminate the vast portion of any downside risk. With the ERTS example, a collar locks in a maximum risk of just $68 over the following four weeks.
This however, is just one simple example. More sophisticated traders will put a collar on a stock and then adjust the collar up or down based on the price movements of the underlying stock. If the stock declines and a loss seems likely, an investor may "roll down" the collar by buying back the existing open option positions and using lower strike price options to enter a new collar with a favorable reward-to-risk ratio. This new collar will have a lower breakeven price than the original position. (Read A Beginner's Guide To Hedging to learn more about how to lower breakeven prices, and reduce the impact of negative events.)
Reward Versus Risk
The key to trading a collar is to seek the maximum tradeoff between reward and risk, with consideration for your preferred timeframe. If you are considering a collar in order to hedge an impending corporate event or announcement, then it makes sense to use shorter term options (i.e., the first expiration month after the anticipated event). If you are looking to collar a stock and to adjust the collar as the stock moves, it might make sense to use longer-term options in order to reduce the number of "forced" adjustments required as each option expires. (Read our article on Stock Option Expiration Cycles to learn more about when options expire, and how you can use them to increase your success rate when trading options.)
The Bottom Line
One of the most powerful benefits of using options is the ability to put the tradeoff between reward and risk solidly in your favor. The long collar is a strategy that very few stock traders ever even consider, let alone employ. Still, this simple technique offers any investor or trader a number of significant benefits including locking in a fixed maximum dollar risk for a specific period of time, protecting against a drop in stock price without having to sell the actual stock and the opportunity to roll a collar's strike prices up or down in order to maintain a favorable reward-to-risk ratio indefinitely. Individuals who truly seek the best opportunities might do well to learn more about this unique option trading strategy.