The Right Tool for the Right Job - Part 2

09/17/2013 8:00 am EST

Focus: OPTIONS

The beauty of options is that there are multiple ways to take advantage of further upside moves while limiting risk, writes Russ Allen of Online Trading Academy.

In my last article, which you can read here, I wrote about the collar strategy, which is a way to make a bullish bet with limited risk. Today I’ll extend that example and describe how you can modify it to make it work better.

The regular collar strategy includes three components:

a. A long stock position
b. A long out-of-the-money put, to protect the stock
c. A short out-of-the-money call, sold to bring in cash to help pay for the put

In this strategy, the put option is bought to bomb-proof the stock position. It is an insurance policy. The call is sold to help pay for that insurance policy.

Last time we started an example with GLD. Here is the chart as it looked at that first article:

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Figure 1 – GLD
Click to Enlarge

At that time GLD was at $133.15. It was rising into an area that had been the origin of the last major down leg in June 2013. It looked as if a new uptrend might be underway. Any investor who bought at any time since the bottom in June was feeling pretty good about it. If the price could get through the resistance around 135, it looked as if it could reach around 140 within a few weeks. But with the 38% drop from the 2011 highs fresh in our minds, we might be cautious about holding on to a long position.

We looked at the collar as a way for such an investor, who already held GLD from lower levels, to preserve most of the profit gained to this point, and still participate in a further move up if it happened.

To construct the collar, on August 22 we could have bought September 130 put options for $1.94 per share. This would insure that if GLD did drop, our loss would be limited. In the worst possible case, if GLD’s price went to zero, those put options would be worth $130 per share.

To help pay for that insurance, we could have sold the September 140 call options for $.71 per share. We would be paying a net price of (put premium minus call premium) = ($1.94 – $.71) = $1.23 for this insurance.

Below is the payoff diagram for this collar position. The individual option prices and other data are at the bottom of the diagram.

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Figure 2 – GLD Collar diagram
Click to Enlarge

From the diagram above, we can see that we could make further profit on GLD up to the $140 call strike, which was as far as we thought it was likely to go by the September option expiration. At any price at or above that $140 strike we would make $5.42 per share. If GLD did not get as far as $140 by then, the call would expire worthless, and we’d still have our GLD shares.

If instead of going up, GLD had another meltdown, the put insured that our loss could never exceed $4.38 per share. That insurance came at a cost of $1.23. The downside of this insurance was that GLD now needed to increase in value by at least that $1.23 for us to do better than we would have done by simply selling out the GLD position on August 22 at $133.15.

Now let’s update this position by a week, and see what else we could have done.

A week after the original example, on August 29, GLD was at $135.70. The September 130 put was at $1.05. The September 140 call was at $1.31. At that point, our P/L looked like this:

NEXT PAGE: Adjusting Your Position

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We had so far made $1.06 in a week, on an advance of $2.55 in the underlying. If GLD held steady at $135.70 until expiration, we’d make another $.26 ($1.31 – 1.05), as both the put and the call lost all of their remaining value. We would not get the full amount of the increase in GLD—but then we would not have potentially unlimited losses, either.

So far, so good.

In this position so far, we bought a month’s worth of time value (in the put), and we also sold a month’s worth of time value (in the call). When the September options expired, we would have to renew our insurance policy if we wanted to keep our protection. We could then do another collar, buying an October put and selling an October call, and so on as long as we wanted to keep doing this.

But not all months’ worth of time value is the same. Options with a long time to live lose their time value very slowly, while those near the end of their lives lose it very fast. We can use this to improve our profitability.

We do this by diagonalizing the collar. Instead of buying a put with just a month to run, we can buy one with several months to run, say six months. In this way, our insurance policy doesn’t have to be renewed every month. One six-month put bought now costs a lot less than six one-month puts bought month after month. Just as importantly, that six-month put costs less than the amount we can get paid for six one-month calls. We can make the insurance self-financing, while still profiting partially from further increases in GLD.

Looking for such possibilities as of August 29, there were March 2014 puts (204 days out) at the 130 strike, offered at $5.90. This is compared to the September puts (22 days out), which were then $1.05, as above. While the September puts (and calls) would lose all of their time value as of their expiration on September 20, the March puts would not—they’d still have over five months to go. If GLD price and IV remained constant, the March puts would lose only $.36—a third of what the September puts would lose.

Looking at this another way, the March puts had over nine times as much time to go, but only cost 5.6 times as much. Our insurance is cheaper when we buy it by the six-pack.

This sounds pretty attractive, and it is. We could conceivably keep our GLD forever with insurance that was very cheap. Not a bad deal.

OK, so what could go wrong?

There are a few things to watch out for. First, we are buying several months’ worth of time value in the puts. If we do this at a time of high implied volatility, then we will pay too much for our insurance. This won’t seem too bad in the first month, since we’ll also be selling calls at a time of high IV. But it will bite later down the line if IV falls. We might not be able to get enough for our future calls to fully pay for our insurance.

So initiating the collar is best done at a time of low IV. Also, the IV levels at any given moment are not the same for all months’ options. The IV of the specific puts that we want to buy might be much higher than that of the front month. In that case, it would not be a good time to put on the collar.

Finally, our insured price is the $130 put strike. If the price of GLD should go a lot higher, then our protection becomes less and less effective compared to the price at that time. Of course, we don’t have to keep that six-month put for the whole six months. We can roll it up to a higher strike at any time. This will cost some money, but always less than the additional profits we’ll already have made if the need to roll it up arises.

With all that in mind, the diagonal collar can be an effective way to maintain a long position with low-cost insurance.

By Russ Allen, Instructor, Online Trading Academy

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