A Protective Collar

In my last post, I discussed a collar strategy. However, this strategy had the underlying assumption that the portfolio has no stock to begin with. The collar strategy was employed to limit risk and reward, given a certain set of speculations. Now, assume that an investor owns 100 shares of LVS (ended the day at $43.35). This investor wishes to keep holding onto LVS until September, but has a worry the company's stock may drop. The stock can not be below $39, when the investor plans to sell the shares (say, to pay for Fall Semester). A rise in the stock price will be welcomed, but not required.

The first option of the investor is to simply put a limit order, where the stock will automatically sell once LVS hits $39. However, if LVS hits $39 in July then rallies, the investor will have sold at the lowest point.

The second option is to buy a simple $39 put. This leaves all the upside, but this put costs $1.35. So, if the stock remains unmoved, the investor only nets $41.65 per share.

To off-set the cost of this 39put, sell an option for $1.35. This turns out to be the 48 call. This is a free collar, as the profit of selling the call pays for the cost of buying the put. If the stock goes up, then money will be made until the stock rises above the price of the sold call.

In summary:

1) Own 100 shares of stock.

2) Buy $39 put, for $1.35

3) Sell $48 call, for $1.35

Maximum risk: $43-$39 = $4 per share

Maximum reward: $48-$43 =$5 per share

Here is the P/L chart comparing the previous collar strategy (no stock) to one with stock. 

Remember an option only collar here involves

1) Sell the 39 put and

2) Buy the 48 put

 OR

1) Buy the 39 call

2) sell the 48 put

 Where the protective collar 

1) Own 100 shares

2) Buy the $39 put

3) Sell the 48call

Notice how the option only collar utilizes only puts or only calls where the protective uses both a put and a call.

"The Most Aggravating Trade Ever"

I saw a caller on CNBC ask about a similar strategy, so here it goes:

Let's say you decide that Las Vegas Sans (LVS) will rise to $47 by September. It is currently trading at $43. The caller asked "should I buy the $47 call?"
The answer is NO! The September 47 Call costs $1.6. So, if you are right, and the stock goes to $47, the stock is on the money, earning no profit. You will lose $1.6.  What is the most aggravating trade ever? Being right - and still losing money!

What about buying the September 43 Call for $3.3? To break even, the stock will have to rise to $46.3. If you are indeed right, and the stock rises to $47, you will only earn $.70. The maximum risk is $3.3.

Here is how you can use a bull collar spread to profit, while limiting downside risk:

1. Buy a $43 call. This will cost $3.3.
2. Sell a $47 call. This will earn you $1.6.

You will start to earn money,
The maximum profit is the difference between the two calls: $4, minus the net cost of the options bought:  $1.7. This will give you the maximum profit of $2.3, with a maximum risk of $1.7 (both options expire worthless).

Let's review our strategies assuming you are correct:

1. Buy a $47 Call. Risk: $1.6. Reward: $0.
2. Buy a $43 Call. Risk: $3.3. Reward: $.70
3. Buy a $43 Call, sell the $47. Risk: $1.7. Reward: $2.3.

Keep in mind that options are represent 100 shares of stock, so a risk of $3.3 is really $330 for buying one option.

What strike to buy?

I just talked to a British trader about Sirius radio. We discussed what option strategy to pursue if he believes the stock price will rise. Unfortunately, Sirius provided problems as an example because the strike prices were too close together and too small to truly show on my graph (premiums of a penny). So, I have picked Home Depot (HD) with the following information:


We believe the price will rise to $50 (so this is a Bullish spread). The question is: which option to buy?

As the strike price increases, the probability of the stock price reaching that price goes down. As such, we see the "time value" of the following options as the following:
 (there is rounding, which is why these numbers differ slightly)
Note there is no intrinsic value because these are out of the money calls.

The green line (strategy #1) is the $35 call, the blue line (strategy #2) is the $40 call and the $45 call is the red line (strategy $3)

Note that as each strategy becomes less risky, its upside reward lessens. Buying the $45 call is cheaper than buying the $35 call, but only earns $5 if the stock goes to $50. On the contrary, if you are wrong and the stock does not move, the $45 call has a max risk of $.05, where the $35 call risks $2.25
The $50 call is On the Money, so buying a $50 call would mean you would lose your $.03 ($3 total).

Well, what about buying an In the Money Call?

Here, we see an In the Money, At the Money, and Out of the Money compared: (notice that strategy #1 - the green line, is now an ITM call)

The ITM call has the best reward payoff, but the most downside risk. If you are wrong, and the option price falls to $25, the entire $10.5 you paid will now be lost. 

There are two more strategies that can not be over looked: a long position and selling a put.

Here is the following information for an At the Money Call and Put:

Selling a put allows you to gain if the stock moves, but you will lose the most from a drop in the price. The red line represents a traditional long strategy. The green line is our ATM call, though this could be exchanged with an OTM or ITM call depending on an investor's goals (as we discussed above)