What's the Collar Strategy?

02/25/2014 10:51 am EST

Focus: OPTIONS

Alan Ellman

President, The Blue Collar Investor Corp.

Option educator Alan Ellman explains the option collar strategy and why he sometimes uses another put strategy.

SPEAKER:  My guest today is Alan Ellman from the Bluecollarinvestor.com.  We’re talking about his covered call strategy, which is what he’s well-known for, but do you use puts with this as well, so Alan, have you ever used puts with a covered call strategy?

ALAN ELLMAN:  Well, a lot of members of the Blue Collar Investor do use puts to protect their positions.  It’s called the Collar Strategy, so the way that works is they’ll buy a stock, they’ll sell an out of the money covered call, and then they’ll buy an out of the money put, so they’ll be protected on the downside, and the example would be, you buy a stock for $48, you sell the $50 all option, let’s say for $2, and you buy an out of the money $45 put for a dollar, so your option credit is a dollar.  Now, if the price of that stock declines below $45 – it can go down to zero – you still have the right to get that stock at $45 and sell it at $45, so you’re going to lose $3 if it goes down dramatically on the share end, and you’ve got a $1 profit, so the worst case scenario is a $2 loss.  Now, if the price of the stock goes up to the strike price of $50, then, in fact, you’ve gained $2 more on the stock side for a total of $3 profit, so many of our members do us in the collar strategy to prevent catastrophic loss.  However, I do not.  I use other strategies for that and that’s well-archived on my website and in my books, but there is one other strategy that I do incorporate puts in, Tim.  I’d like to explain it to you now.

SPEAKER:  Sure.

ALAN ELLMAN:  I call it the put-call-put strategy, PCP, and it works like this.  In bearish market conditions or if you’re concerned about the market, you’re worried that it might go down but you still want to generate a monthly income.  What you could do is sell an out of the money cash secured put.  Cash secured means that you put the money into your brokerage account, so if that put is exercised, and you are asked to buy those shares, the money is already in your account.  However, if that happens, you’re purchasing those shares at a discount.  Let me give you a quick example.  Stock is selling at $75.  You like the stock; you’re worried about the overall market, so what you do is you sell an out of the money $72.50 cash secured put.  If the price of the stock never goes below $72.50, that option will not be exercised, but you’ll be generating an option premium from the sale of that put, say 3%, one month.  Now, if the price of the stock does decline below 72.50%, those shares will be put to you and your cost basis then, will be, let’s say, $70.50, if you sold the put for $2.  You buy at $72.50 and you generated $2 profit on the sale of the put.  Now you own the shares at a cost basis of $70.50—you can now sell the covered call.  Selling the covered call obligates you to sell your shares at a certain price.  If the call is not exercised, you could sell another call the next month; thereby generating another monthly premium.  If the shares are called on you and you sell the shares, now you have the cash in your account to now secure another put and so the process goes, but every month you are generating option premium.

SPEAKER:  Alright, we’ve just scratched the surface.  There’s a lot more on your website.  Tell us what it is.

ALAN ELLMAN:  The website is Thebluecollarinvestor.com.  You could reach me—I also answer all my emails at:  alan@ thebluecollarinvestor.com and there’s lots of information there on this topic.

SPEAKER:  Alan, thanks for your time.

ALAN ELLMAN:  My pleasure, Tim.

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