- 2002: Volume 11, No. 2 Puts & Calls: Tracking the Great Collar Strategy

Collars, or hedge wrappers, can be used either to hedge a stock you already own or to enter a new strategy, looking to profit from the move of an underlying security. The strategy consists of buying actual stock (we'll assume 100 shares), buying a put and selling a call. This combines the affects of a covered call with a protective put kicker. Depending on what strikes a trader uses, a collar can be neutral, bearish or bullish. In the following example, we are going to enter a forward hedge wrapper, which means we are going to take a slightly bullish position.

Real World Example
Though I have a feeling the markets will continue to struggle for the next month or so, I want to demonstrate how to take this position by following a real world trade to see how the strategy works. Let's use a stock that has proven itself even in negative markets: Wal-Mart (WMT). Unlike most stocks, WMT has been able to rise the past few months, reaching a 52-week high on Wednesday. This makes the stock a good candidate to learn how a collar works. Below is the information about the Wal-Mart collar we will track.

February 13 Buy 100 shares of WMT @ 60.12 Buy 1 March 60 Put @ 1.85 Sell 1 March 65 Call @ 0.20 Total Debit = 6177.50 Max Risk = 177.60 Max Profit = 322.50 Breakeven Price = 61.78

The total debit figure may be reduced nearly by half if you buy the stock on margin. What we have done here is cap our upside, but protect ourselves in case Wal-Mart shares fall sharply. Wal-Mart looks strong here, but what if the market really falls and Wal-Mart shares fall with it? In this case, the put we purchase will protect us from losing too much capital. However, in order to lower our cost, we are willing to cap our upside. If the stock moves sharply higher—well above $65—we would miss these gains as well.

In order to show how this strategy works, I have chosen the March expiration month. However, this is not the ideal way to enter a collar. Time erosion hurts this strategy, but the next month available for Wal-Mart options is June and I want to show how this strategy works from start to finish.

Lower Costs and Protect Positions
The strategy is often used to protect shares already owned. We might own Wal-Mart shares already and want to protect ourselves in case the market falls sharply. At the same time, we can lower our cost to buy the put by selling the call. In essence, we have a bull call spread and a protective put play wrapped in one.

Notice that the breakeven for this play is 61.78. This is found by taking the maximum risk of 177.60 and adding it to the price of the put. At expiration, the maximum loss occurs if the stock is trading below 60. However, even if the stock moves to 50 or 40, we still only lose 177.60. The maximum profit of 322.50 is achieved if WMT closes at or above 65 at expiration. I haven't talked about implied volatility, because it has a minimal effect on a bullish condor trade.

Now let's see how this trade worked over the next four weeks.

February 19 100 shares of WMT - 59.29 1 March 60 Put @ 1.80 (Bid) 1 March 65 Call @ 0.20 (Ask) Total Debit = 6177.50 Max Risk = 177.60 Max Profit = 322.50 Breakeven Price = 61.78 Current Loss if closed Out at above prices - 88.50

After a week of trading and with Wal-Mart down slightly, our loss, if closed out at the above prices, would be just 88.50. A collar is not a fast-moving strategy and is normally held until expiration. Our ideal trading scenario would be that Wal-Mart shares close right on $65 at expiration. This would let us keep our stock and bring about our maximum gain. Obviously, the overall amount of money made would be greater if we just held the stock until it reached $65, but this would be done with much more risk, as the stock could fall all the way to zero. Is this likely to happen? No, but Enron has shown us that even very large companies can fall into serious problems. A severe market decline could easily take Wal-Mart shares lower, even if the company is solid. Remember that a collar strategy is normally used by traders who already own stock and want to protect themselves, but don't see a major move higher in the underlying security.

We could have increased our possible profit on the collar by entering a lower strike put. This would have cost us less to buy, but would have also left us with more risk. Each trader needs to make decisions based on their view of the market and risk tolerance. Some traders enter what is called an "even" collar. This would be when the put price is totally offset by the call price. Sometimes there is a discrepancy between the prices of a call and put equal distance from the stock. On the other hand, a trader may buy a further out-of-the-money put and a closer in-the-money call. In our example, we did just the opposite. We purchased a put that was at-the-money and sold an out-of-the-money call. As a result, our risk is lower, but we had to pay more for the protection.

As you can see, a collar can be tailored to fit various situations, but is normally used as a vacation trade. This means that it doesn't take a lot of tracking and a trader can go on vacation without worrying about the movement of the stock. One reader asked me why we would choose a stock that is not likely to move higher because of a choppy market. This person stated that we were unlikely to have Wal-Mart shares called away. Actually, this is just fine. We don't want the stock to rise or move dramatically higher because we would miss any gains above 65. Rather, we hope WMT shares move to around 65 and we are able to keep our stock.

February 26 100 shares of WMT - 62.10 1 March 60 Put @ 0.50 (Bid) 1 March 65 Call @ 0.30 (Ask) Total Debit = 6177.50 Max Risk = 177.60 Max Profit = 322.50 Breakeven Price = 61.78 Current Gain if closed out at above prices - 55.50

If we closed out the collar at current prices, we would have a mild gain. But a collar is not a strategy that is usually closed out early. (Note: I used short-term options so we could follow the example from start to finish, but this is not usually the best way to do it.) In fact, some traders will buy a longer out put and then sell the calls each month to bring in a small premium. This way, after some time, the put may be paid off, but the movement of the stock can dictate which calls to sell. The point is, there are many differing views on how to use a collar or if to use one at all. Some traders would prefer to protect their portfolio by the flat out purchase of puts. This costs more up front, but does not cap the upside potential of the stocks owned.

Peace of Mind
The biggest problem with insurance is we don't appreciate it until we have to use it. I guarantee that anyone who paid for protective puts or had collars in place on Enron shares is glad they did so. However, just like life insurance, we hate to see premiums paid for something that is not being used. But, sometimes, peace of mind is enough to validate buying the protection.

The problem is that most of us are not aware of the risks until it is too late. During the bull run of the 1990s, I'd bet most traders weren't too worried about a major drop in stock prices. As a result, I'd further bet that protective puts and collars were not in vogue. However, those who placed these types of insurance in place look like geniuses now, even though they were just buying insurance. Obviously, if one really thought stocks were going to tank, they would purchase puts and sell stocks.

March 5 100 shares of WMT - 60.76 1 March 60 Put @ 0.70 (Bid) 1 March 65 Call @ 0.15 (Ask) Total Debit = 6177.50 Max Risk = 177.60 Max Profit = 322.50 Breakeven Price = 61.78 Current Loss if closed out at above prices - 46.50

Until Tuesday, Wal-Mart shares were trading near $63, a 52-week high. However, a number of retail companies were downgraded on Tuesday due to valuation concerns and this led to a drop in the retail sector. As a result, WMT shares finished the day down 3.52 percent. Even so, if closed out at current prices, our collar would lose roughly $50, not including commissions. Thus, we the beauty of protective strategies is proven once again.

March 12 100 shares of WMT - 62.23 1 March 60 Put @ 0.10 (Bid) 1 March 65 Call @ 0.10 (Ask) Initial Debit = 6177.50 Max Risk = 177.60 Max Profit = 322.50 Breakeven Price = 61.78 Current Gain if closed out at above prices - 45.50

Review
Let's review why we use a collar and how we enter this hedging strategy. First, a collar is used to hedge a stock. Normally, this is done on a security that a trader has made some paper gains in. If a trader is afraid the market may drop, a collar could be entered to insure against the losses if the stock does fall. A collar is made up of buying a protective put, normally below the stock price, and selling a higher strike call. If a collar is entered with approximately the same distance between the underlying and the options, it can be done for virtually no money down. Much like our trade, collars can also be placed using strikes that aren't equidistant from the stock. This just creates either a more bearish or bullish collar. The drawback of entering a collar is that if the underlying rises sharply, a trader could have the stock called away, losing any profits above the sold calls strike price.

When to Use a Collar
Collars don't make much sense as a profit-making strategy because there are better strategies to enter. However, if a trader wants to hedge against a major decline and do it virtually for nothing, a collar is a nice choice. If you are worried about missing the upside, then either sell a higher strike call or just purchase the protective put. This will cost you a little more out-of-pocket, but will eliminate the risk of missing out on a substantial gain in the stock.

In our Wal-Mart example, we bought a put just below the current stock price. This basically protected us from any move below $60. However, since we sold the 65 call, we had some out-of-pocket expense. In a real trade, we probably wouldn't enter a collar using the front-month options. I did this to show how the strategy works from start to finish, but hedging is best done using further out options. This way your options premium doesn't evaporate so quickly. Though this example was short of perfect, let's face it-the markets have just been that way lately. In this light, it was a great way to show how a collar actually works in real-world trading.

Joel Addison is a senior writer and options strategist for Optionetics.com, a comprehensive Web site which offers traders an exciting journey into the world of trading by providing stock and option fundamentals, low risk strategies, and daily market insights that will enable you to navigate the markets successfully. Check us out at www.optionetics.com or visit Joel's forum at: www.optionetics.com/bbs/forum.asp?forum_id=40&forum_title=Ask+Joel+Addison.