Q&A: The Diagonal Collar

07/22/2014 8:00 am EST

Focus: OPTIONS

Lawrence McMillan

Founder and President, McMillan Analysis Corporation

Options expert Lawrence McMillan of McMillan Analysis Corporation shares a question-and-answer between him and a subscriber about the diagonal collar.

Question: As an alternative to buying fixed income, which yields next to nothing these days, I am constructing a no-cost collar on a dividend paying stock using a six month ATM long put and writing one month calls against it. I am not worried about getting called away and missing out on an upside stock move, but I don't want to get called away the day before the stock goes ex-dividend. I am making the assumption that I probably won't get assigned on the short call except on that one day. My plan is to watch the call premium closely and, if it I see it fall near or below the quarterly dividend payment, roll out to the next month before I get assigned.

In general, the plan is to have maximum downside protection at no cost while collecting the dividends. Does this make sense?

Answer: In theory, yes, that would make sense.  But there are practical problems. First of all, let me correct one statement you made: you won't be in danger of assignment unless the call loses all of its time value premium-not when the call's time premium is lower than the dividend.

Also, why a 6-month put?  If you are planning to let the stock be called after you collect the dividend, maybe you want to gear the put's expiration date to be something just after the projected ex-dividend date.

You don't say which call strike you plan to write, but if you use something slightly out-of-the-money, you probably shouldn't worry about getting assigned, even if it is for the dividend.  The gain in the stock price up to the call's strike could be ample consideration for letting the stock be called away.

However, if you want to roll calls for a credit in order to avoid being assigned for the dividend, that could become very difficult if the stock rallies strongly before the ex-dividend date.  On high-yielding stocks whose options have low implied volatilities, it is often difficult to roll in-the-money calls forward for a credit.

Probably the biggest difficulty will arise, though, if the stock falls.  You should not write calls at lower strikes than the put strike, because you could lock in losses on a reflex rally.  Furthermore, in the case where the stock falls, calls at strikes higher than the put strike may be extremely low-priced, thus providing little credit.  So, if the stock remains low, you may not be able to recover the cost of the put by selling calls. 

In fact, if the stock moves away from the original put strike much at all, you won't be able to generate credits and you may wind up with a loss on the whole position due to the cost of the put.  

All strategies that involve buying a longer-term option and then planning to sell short-term options against it repeatedly have this same problem.  They don't work if the underlying stock makes a strong move in either direction before you've had a chance to take in enough credits to recoup the cost of the long-term option.

By Lawrence McMillan, Founder and President, McMillan Analysis Corporation

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