The stock market has made a number of new highs. So protective puts and other option strategies designed to defend against downside moves may not be foremost in every investor's mind. But corrections happen in every market; it’s only natural.
But if you are an options trader, perhaps this holiday season is a good time to consider accessorizing your stock position with a collar. Or, if you’ve already been using collars to attempt to protect a stock position, this year’s bull market may be a good time to make collar adjustments.
Anatomy of a Collar
The basic collar is constructed of three parts: the stock, a long out-of-the-money (OTM) put option, and a short OTM call option with the same expiration date. The put is there to help protect you in case of an adverse move downward in the stock. The premium collected from selling the call can help pay for the put. For example, suppose a stock is trading at or around $100, and the 90-strike put and the 110-strike call are both trading for $2. In this scenario, you could sell the call and buy the put for no net premium outlay (what’s known as a “zero-cost” collar). But don’t forget to include transaction costs in your calculation.
The risk profile of this collar is shown in figure 1. It’s worth noting, however, that OTM call strikes typically trade at a lower implied volatility than equidistant OTM put strikes, and thus often trade at a lower premium. So you may need to choose either to alter your strike choice, or accept a bit of premium outlay.
Stock Moves Up? You Could Straighten Your Collar and Roll Your Risk
Options don’t need to be held all the way through expiration. If the stock moves before expiration, you can consider adjusting or even closing the collar. If you can, think of your put option as a floor, and the call option as a ceiling. In a market that’s moving higher, you can make adjustments to raise the floor and/or raise the ceiling to accommodate the rising stock.
Let’s say the stock moves up to $105 after two weeks. Using the prices from the sample option chain below, you could use a long put spread order to roll your 90 put up to the 100 strike for $1 ($1.20 – $0.20), plus transaction costs.
|Stock = $105||Call Bid||Call Ask||Strike||Put Bid||Put Ask|
Your put protection would now be $5 below the current price of the underlying stock. Note that, in this example, the call is still OTM by $5, and if the stock remains below the 110-strike through expiration (but above the 90-strike), both the call and the put will expire worthless.
If the stock rallies, however, you may be assigned, which means you’ll likely need to sell your stock at the call's strike price. But because you would have held the stock from $100 to $110, that represents a $10 gain. However, you'll miss out on any of the stock's appreciation beyond the 110 strike price.
Alternatively, you could consider rolling the call to a longer-dated option, perhaps a higher strike. And if you're still interested in protecting the downside, you could also consider rolling the long put. This is a strategy employed by many option traders. For more on rolling option positions, please refer to this primer.
And what about the opposite case—if the underlying were to move down after initiating the collar? In a future article we’ll look at other adjustments you could make with your collar.