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Using LEAPS With Collars
11/07/2012 7:00 am EST
Today’s election results will hopefully resolve one of the uncertainties plaguing the markets, but with many others still unresolved, the staff at Investopedia.com detail a strategy that can provide great protection in an uncertain market by limiting losses while locking in healthy, predictable profit.
Many investors have been in a situation where they wish to lock in profits while keeping their existing upside potential. For example, employees who have most of their 401(k)s invested in company stock may want to hedge against any sudden downturn in the company, while investors lucky enough to have struck gold with a solid stock may want to reduce some of their risk and lock in profits. Traditionally, this has been done by purchasing put options. The problem is that this strategy costs money. This article will cover how to lock in profits using a different and more economical strategy—collars.
A collar is a stock option strategy in which an investor purchases a put while simultaneously writing a call against the stock position. The most common collars are constructed by purchasing one put and writing one call for every 100 shares of underlying stock that you own. The put provides downside protection, while writing the call finances the purchase. The end result is a "free" way to lock in profits in which the only downside is the fact that your upside is limited. After all, the written calls will force the investor to sell his or her underlying stock position if the stock price rises above a given price before expiration.
Here's what the option's profile looks like:
Here are the key calculations for this strategy:
- Maximum Risk = Cost of Put - Credit from Call
- Maximum Profit = Differences in Strike Prices - Net Debit Paid
- Breakeven Point = Current Stock Price + Net Debit Paid
Using these calculations, you should be able to quickly calculate all of the possibilities for your stock position. Note that there is no real breakeven for this strategy because it is a neutral strategy, but the above calculation will tell you how much you need to make up to break, even on the cost of setting up the trade in the first place.
Example 1: Creating a Collar
Let's say you own 100 shares of a stock that trades at $50 per share. To create a collar, you can sell a call option with an exercise price of $60 and buy a put option with an exercise price of $40. The call options sell for $1.20 each while the put options sell for $1.10 each. The position results in a positive credit to your brokerage account of $10!
Now, if the stock moves below $40 you have the ability to sell the stock for $40 with the put option you purchased, no matter how low the stock goes. If the stock rises to $60, however, you may be forced to sell at $60. While this is still a nice profit, you are not able to capitalize on any larger moves to the upside. Many consider this a small price to pay for the peace of mind that comes with full protection.
The dynamics of a collar can vary greatly depending on the situation. Investors have the option of writing zero-cost collars, in which writing calls fully offsets the cost of purchasing the puts (or may even result in a premium). Other investors may wish to increase their profit potential while just seeking disaster insurance, which can be accomplished by "loosening the collar," or writing calls that are more out-of-the-money. In the end, investors must decide whether they wish to preserve their capital or increase their room for profits.
In general, the longer the collar is, the better the risk-reward profile of the entire position will be. The longer-term hedges are cheaper to establish and, therefore, result in a less "risk" (cost) for the same "reward" (strike prices). The problem is that a longer time frame means you are locked in and can only get out by unwinding the position. This becomes a problem because attempting to unwind a position in a bullish time frame will rarely allow you to profit from the end trade. If the position becomes more volatile, however, the risk-reward proposition improves dramatically.
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LEAPS Index Collars
Collars are great for hedging against company-specific risk, but what about investors who are looking for a hedge against larger economic downturns? It may be possible to purchase collars on every stock in a portfolio, but it would be expensive and impractical to establish such a position. Instead, investors may consider purchasing a collar against an index that closely mimics their portfolios. But, this is not possible because you cannot write naked calls against such a large number of stocks! Investors may be comforted to know, however, that they can purchase index puts on long-term equity anticipation securities (LEAPS) as a viable alternative.
Example 2: Creating a LEAP Index Collar
Let's say you own a diverse portfolio of stocks with names such as Intel (INTC), Microsoft (MSFT), Exxon Mobil (XOM), Wal-Mart (WMT), Pfizer (PFE), and others. To hedge against the market risk of this portfolio, you can simply purchase puts against an index representing all of these stocks. The best choice would likely be the S&P 500 Index (SPX) because it contains all of these stocks. Just as with stocks, the quantity and strike price of the options depends on the amount of insurance you wish to have on the portfolio.
Now, if the stock market takes a sudden turn and some of your portfolio value is erased, you should theoretically make back nearly that same amount with your put on index LEAPS. The time and price at which you are able to begin collecting, however, depends on the time and price of the index LEAPS strikes you purchased on the puts.
The downside of the LEAPS index puts is that they can only be used on portfolios that already mimic an index. Portfolios holding many unknown small-cap or micro cap companies often cannot use this strategy as the movements would be too different. In fact, the strategy could become disastrous if the two do not have any correlation because you could suffer uncovered losses on both ends of the trade!
The Bottom Line
Collars can help investors hedge a portfolio by setting a maximum loss. In some cases, they can even result in a small credit. However, collars can become a problem when your stock starts making a lot of money because your upside is limited by the call options sold to establish the position.
Investors looking to hedge against macroeconomic risk can purchase puts against index LEAPS to make a collar-like position (without the upside limitation) that should (in theory) limit losses in the event of a market downturn. In any case, collars can provide you with great protection in an uncertain market by limiting losses to a set number while enabling you to lock in a healthy and predictable profit.
This article was written by the staff at Investopedia.com.
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