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Using Option Collars to Reduce Risk

BLOG, EDUCATION  |  13 Jul 2010

Many people think of stock options as a risky investment strategy used mostly by highfalutin Wall Street types with millions to burn. While it’s certainly true that you can get yourself into trouble with an ill-advised option position, options can also be used to effectively reduce portfolio risk. One option strategy that can do this is called “collaring”.

Collaring uses options to greatly reduce the risk inherent in a stock position by putting a limit on the possible losses, with the trade off of limiting the upside. The most basic use of an option to reduce downside risk in your portfolio is the purchase of a Put. When you buy a Put, you are buying the right, but not the obligation, to sell your stock at a certain price.

First, a couple of definitions:

Put Option -A Put option gives the owner of the Put the right, but not the obligation to sell stock at a certain price by a certain date. A single Put option contract covers 100 shares of the underlying stock

Call Option -A Call option gives the owner of the Call, the right, but not the obligation to purchase stock at a certain price by a certain date. The person who sold the Call is obligated to sell his stock at the strike price of the option if the Call owner exercises his right to do so. Like a Put option contract, a call option contract covers 100 shares of the underlying stock.

Strike Price – The strike price is the price noted on the option that dictates whether the owner of the option is able to exercise his rights.

Example:

You own 1,300 shares of Amgen (AMGN) that has a current value of $55.50 a share, thus your holding is worth $72,150 currently.

One of your primary concerns is capital preservation, so you’d like to protect your portfolio against a big drop in the value of your AMGN stock. You’ve decided that you’re not comfortable with the thought of that stock dropping much below $50 a share. Let’s assume that right now that it’s May. You learn that there are Puts available for AMGN. Some of the put options available are the October $50 Puts. Purchasing these puts would give you the right to sell your AMGN stock at $50 a share between now and the date the put expires in October in the event that the market price of AMGN is below $50/sh. So you go ahead purchase 13 put contracts for $177.00 each or a total cost of $2301.00. [$1.77 (cost per share) x 100 (number of shares per contract) x 13 (number of contracts purchased) = $2,301]

Now that you have purchased these Put options, you not only have the right to sell AMGN for $50 between now and October, you also have the right to sell the Put options themselves. If the price of AMGN stock goes down, the value of your Puts goes up. If the value of AMGN drops between now and October, the value of each Put option will increase by about a $1 for each dollar below $50. Thus, if we are near the third Friday in October (options expire on the third Friday of the month), and the value of AMGN is $40, each Put option price should be near $10 per share, causing the value of your puts to increase to $13,000. [$10 x 100 (number of shares per contract) x 13 (number of contracts) = $13,000] Now you have a choice to either exercise the option and sell the stock at $50 a share, ($50 x 1,300 = $65,000) or keep the stock and sell the options for $13,000, which offsets your loss on the stock below $50 a share.

By just owning Puts, your upside is still unlimited, but your downside is limited .One drawback of this strategy is that Put contracts come at a cost. These costs can add up over time and hurt portfolio returns. However, there is a way to offset the cost of the “put” insurance. This can be accomplished by selling Calls on the AMGN stock. Selling Calls generates income which can be used to pay for the Puts. This is what is meant by the term collaring, which is simply the practice of buying Puts and selling Calls on the same stock. Here is an example:

Since the cost of the put protection alone can be very expensive over time, we can sell Calls to implement the collar strategy. Using the same example from above with AMGN trading at $55.50 a share, we learn that the October Calls with a 60 strike price are selling at $1.72 a contract. By selling Calls we can generate $2,236.00. [$1.72 (price of call per share) x 100 (shares per contract) x 13 (number of Call contracts sold to cover all 1300 shares owned) = $2,236]

By selling this Call with a strike price of 60, we are obligated to sell our shares of AMGN to the buyer of the Call if the shares of AMGN rise above $60 a share between now and October. However, we have offset the cost of the Put protection with the proceeds from the sale of the Call options, leaving a net cost of $65 for implementing the collar strategy. [$2,301 (cost of Puts) – $2,236 (proceeds from selling Calls) = $65] The stock is now protected if it falls below $50 a share, but its upside is limited up to $60 a share.

Now 3 things can happen:

  • The price of AMGN can stay within the range of $50 to $60 until October. If this happens, both the puts and calls expire worthless, and we would consider initiating another collar to keep protection in place. The $65 is considered a cost of insurance.
  • The price of AMGN, could fall below $50 a share between now and October and we can either sell the shares at $50 or sell the put option (which has now increased in value) to offset any loss resulting from the stock’s decline.
  • The price of AMGN could rise above $60 a share between now and October, in which case the stock can either be called away (meaning we will have to sell it at $60 a share) or we can repurchase the calls we sold. If we repurchase the calls that were sold, this cost would be offset by the rise of the stock above $60 a share, so we have still limited the gain on the stock to $60 a share, but have retained ownership of the shares of AMGN.

Example: AMGN is at $63 a share near the expiration date in October, and we decide we still want to hold onto the shares of AMGN instead of having them called away at $60. The value of the Calls is now around $3.00 a share, so $3 a share x 100 shares per contract x 13 contracts = $3,900 to buy the calls back, but the 1300 shares of AMGN are also up $3,900 ($63 – $60 = $3 a share x 1,300 shares = $3,900), so the net effect is we only participated in the gain in AMGN up to $60 a share during the time the options were held.

We can also use different time frames, and use options with expiration periods longer than just a couple of months. This is generally what we would do in order to avoid having to make frequent adjustments to the collar.

Tax Effects – Quite often, options expire with no value. Depending upon which side of the transaction you were on, this results in a gain or a loss. Investors are required to recognize the gain on the sale of Puts in the year they expire, but any losses resulting from Puts cannot be recognized until the stock is sold. Also, whenever options are exercised (which results in the sale of the underlying stock) there will likely be a gain or a loss on the sale just as there is in any normal stock transaction.

Although the Collaring strategy does produce some additional taxes, they are fairly modest and can be avoided by implementing the strategy in an IRA account. Where that isn’t possible, the tax consequences have to be taken into consideration and weighed against the benefits of the strategy.

In order to introduce you to what may be a new concept, we have simplified this discussion of option collaring. We intentionally omitted a detailed discussion of how options are priced and what factors affect option prices. Also, the example we used here did not consider commissions, which are generally not much of a factor. It is also important to also note that the Collar can be implemented for both stocks and market indexes. Collaring is considered a conservative strategy that does a good job of preserving capital over time. Collars allow you to have exposure to the stock market while limiting the downside to a tolerable, predetermined amount. The trade-off is that you give up some upside potential. For investors concerned about preserving wealth while allowing for modest growth, collaring options can be a very effective strategy.