Monthly Archives: September 2011

Using equity collars for protection

The equity collar consists of a short call and a long put married to
a position in an underlying investment.It is also referred to as a collar option. It is especially useful for owners of concentrated equity positions. Say, for example you are employed at ABC Corp and are nearing retirement and been fortunate enough to accumulate 20,000 shares of ABC which is now at $50 per share. The million dollars that you have in ABC is a substantial portion of your net worth. Retirement is two years away and you can’t sleep at night because a decline in the price of ABC could seriously impact your ability to retire. At no cost you can sell call options on your position and use the proceeds from the call options to purchase put options. You can evaluate a wide range of strikes to determine which combination is best for your individual situation. You can sell at the money calls and buy at the money puts in which case you are basically locking in the price of ABC and saying that you are content with that price level and are willing to
sacrifice further upside gain in order to prevent any loss. You can also use a
call spread instead of just a covered call, that way if the stock makes a large
move to the upside you’ll participate in any gain above that highest strike of
the spread. You can use it as an income producing strategy by selling calls
slightly out of the money and buying puts further out of the money for a net
credit. That way you are retaining some of the call income for your use and you
are setting the maximum downside risk at a pre-determined level that you are
comfortable with. Investors who decide to collar an entire position are never
happy if they the price rise substantially after the collar is put on and they
don’t participate in that gain. There are a couple of ways to leave some room
for upside gain and still have some downside protection. One is simply to only
collar a portion of the position. With the 20,000 shares of ABC for example, we
could decide to only collar 10,000 shares that would leave 10,000 subject to
market risk and 10,000 protected from price decline. The ratio chosen depends
on the financial goals and emotional makeup of the investor. The other method
for participating in an increase and still have a collar is to use a call
spread instead of just a covered call. If ABC is at 50 for example we could
sell the 55 call, buy the 45 put and buy the 60 calls. If ABC makes a large
move, such as a takeover of the devepoplemnt of an exciting new product, we’ll
participate in the upside gain above $60. When using call spreads ratios can
also be employed, the options don’t have to be in a one to one ratio. For example
with the 20,000 shares you could sell 200 of the 55 calls, buy 200 of the 45
puts and buy 100 of the 60 calls for the upside gain potential. The
combinations are virtually limitless and the ideal combination depends on the
investor’s unique situation. If exchange trade vanilla options don’t provide
the strike prices and expirations that match your goals, this is an area where
using the FLEX options can make a lot of sense. What I do as an RIA is
thoroughly evaluate our client’s needs and situation, then run calculations on
the various option combinations to see what will work best for each investors
unique situation. The proprietary calculations that we use involve solving
equations in multiple variables. We’ll consider the overall position delta, gamma,
and theta. If the investor’s goal is to be delta neutral at the onset we’ll
sell a 50 delta call and buy a 50 delta put. If the position is put on for a
net credit, the delta will work in our favor and provide some income. If put on
for a net debit, the theta represents the daily expense of maintaining the


The naked put, selling puts to accumulate stock

The uncovered or naked put is sold when an investor wants to produce income and is willing to accumulate shares of stock. The key difference between an investor and a speculator when it comes to naked put selling is that the investor is targeting a stock or ETF for a long term buy and has set a price that he is willing to purchase that stock at. The speculator is trying to profit by selling the put and hopes it will either expire worthless or he can buy it back later for a profit.  The investor is satisfied with either outcome having the put expire worthless or getting assigned and purchasing the underlying shares at pre-determined price. Income is produced by selling out of the money put options at a price lower than the current price of a stock, when the investor would be willing to buy the stock at that price.  For example, if XYZ stock is trading at $25, the investor is willing to purchase XYZ at $20. Therefore, she sells a $20 put for $1.  If the stock stays above $20, the investor retains premium. If the stock goes below $20, it will be put to the investor at $20.  However, the investor already has collected $1 in premium so her cost basis is $19.  There are many sources that consider naked put selling to be a risky strategy. However, selling an uncovered put is not as risky as outright stock ownership. If an investor owns a stock that goes to 0, like General Motors, the investor has a total loss. If the same investor sold a put and was assigned on that put to purchase those GM shares, the investor would have retained the put premium even though the shares eventually went to zero. Naked put selling is riskier to the brokerage house because they fear that the investor may not meet the margin call if shares are put to her. If the investor utilizes proper position sizing relative to her portfolio and is using the strategy for stock accumulation uncovered put selling is not a high risk strategy and in fact has the same risk profile as the covered call strategy which is generally considered to be low risk. When stock prices decline, implied volatility has a tendency to rise making the options more expensive. If you’re targeting an entry price for a stock and see it decline rapidly, check the option quotes for a rise in the implied volatility and high prices for out of the money puts. When bad news comes out on a stock that you want to own, that can be a good time for selling out of the money puts. Say you’re willing to accumulate 1000 shares of XYZ over time. You could sell 10 out of the money puts and wait for the shares to get put to you or you could use a fraction of the total, say 2 puts per month and repeat the process until you’ve accumulated the full 1000 shares. When selling naked puts we target investments to accumulate, a price below the current market that we’re willing to buy them at and try to find puts that are relatively expensive. If you’re accumulating shares of a stock, puts will have a tendency to be priced high every quarter prior to the earnings release. This can create an opportunity for the put seller as the implied volatility rises to account for a substantial move in the stock. Out of the money puts can have a higher price at this time and provide an attractive entry point. For investors wishing to accumulate shares in a commodity based ETF such as USO, the oil ETF, the volatility can be higher before the weekly release of the petroleum report. Stock index ETFs can have higher implied volatility prior to major releases of
economic data like the monthly employment numbers or scheduled Federal Reserve meetings. When selling a put you can use the delta to approximate the probability of getting assigned at expiration. An at the money put will have a 50 delta, so if you sell an at the money put you have a 50/50 chance of ending up owning the shares. The at the money puts also have a relatively high premium and will have high theta. As the puts move out of the money the delta is lower so the probability of getting assigned also gets lower as you move out of the money. If you sell 20 delta puts the premium may not be that high, but you’ll only get assigned 20% of the time and your entry price into the underlying will be substantially below the current market price.  If you are targeting individual equities with this strategy, you will only get assigned when the stock drops significantly, and you may decide you don’t want to own that stock anymore. It’s very critical to be sure you’re willing to purchase a stock when selling puts. When the strategy is used to accumulate ETF shares in a broad based index like the S&P 500 for example, by selling far out of the money puts on the index, you’ll only buy shares on dips and it can be a good dollar cost averaging strategy for share accumulation in an index fund.

P/L Graph for SPY Naked Put

SPY Short Put

Put options for portfolio insurance ~ the married put

The long put option is similar to the long call option in that the
investor has the right but not the obligation to exercise. The purchaser of a
put option has the right to sell the underlying at the strike price on or before the expiration date in the case of an American style option or on the expiration
date if the investor owns a European style option. The owner of a put will
participate in the downside of the market with risk limited to the premium or
price paid for the put contract. Puts can be purchased to profit from a price
decline in a stock, an index or a commodity. For example if you own an all
stock portfolio with 20 holdings and are concerned about a general price
decline in the market, you could purchase a put on a broad based index that
would increase in value if the market declines. The tactical option investor who
purchases a put that is not used to hedge a portfolio against a market decline
is considering a couple of different factors. The first is an analysis of the
underlying to determine if it is overpriced or not. There are a variety of
fundamental research sources that can be used to help determine if a stock or
an index may be overvalued. Once we have determined some overvalued investments to consider, then we study the charts and consider the momentum of the investment. An individual stock or a commodity for example may seem to be overvalued but its price momentum can continue upwards for long periods of time and they can become even more overvalued. The application of some technical analysis can find investments that are overvalued and have some downward price momentum. A moving average crossover can be a good simple tool to apply. The third step is to indentify underpriced put options. You can find an overvalued stock in a downtrend and if you pay too much for the option it may not produce a profit. To locate undervalued options you need to consider the historical volatility of the stock, the implied volatility of the option and study the history of the implied volatility to see where the implied volatility is relative to its long term averages. The difference between a speculator and a
tactical option investor in these types of transactions is that the tactical
option investor will have a fundamental opinion on the underlying investment,
apply some technical analysis to see if the price momentum is favorable and
find a reasonably priced option. The tactical option investor will also buy an
option with sufficient time remaining in the contract for the price movement to
develop. Many option speculators experience failure because they don’t take the time to properly analyze these three steps and they trade in too short of a
time frame. There is much work to be done when taking directional trades with
options, the markets are very efficient and arbitrage opportunities rarely
exist.  Using a long put to hedge a portfoliois different because the investor chooses the option contract based on hisunderlying portfolio and is concerned about portfolio protection or insurance. Puts used for portfolio insurance are known as protective puts. Married puts are put options that are tied to a certain number of shares of a specific stock.


The Covered Call

The covered call is one of the most common strategies employed
by individual investors. The covered call writer is moderately bullish to
neutral in his market opinion and is willing to sacrifice some upside gain in
order to collect the premium from the sale of the call contract. The risk of
the underlying stock position is reduced by the amount of the call premium
received. Call premium is received into the investors account as immediate
income. For example an investor may buy 100 shares XYZ stock at $25.00 and
subsequently sell 1 October $30 call at $1.25. At expiration if XYZ is above $30, the investor will have the stock
called away.  When below $30, at expiration the investor will keep the shares, any gain between $25 and $30, and
the call premium of $1.25. Her cost basis in the stock is now also reduced to
$23.75, the initial price of the stock minus the premium received for the call.
Numerous academic studies have been done on the covered call strategy and one
of the conclusions drawn from them is that covered call writing can not only
enhance portfolio return, but the strategy has been shown to provide those
returns with lower risk. The volatility of the underlying fund or stock can be
significantly reduced by employing a covered call writing strategy. Since the
delta of an at the money option is 50 and the delta of the underlying fund is
100, if an investor sells an at the money option, the position delta is reduced
to 50, so that position has about half the risk of the underlying position as
long as the option stays at the money, as long as the price of the underlying
does not move very much. Another Greek that the covered call writer wants to
monitor closely is the theta, or rate of decay. The theta tells the option
writer how much money she’ll earn daily just through price erosion. At the
money options will have the highest theta.  Say for example that an investor sells a
slightly out of the money option for $2 at the beginning of the month, not the
first calendar day of the month, but the first Monday following the third
Saturday of the month. If the underlying price stays steady or declines
slightly in the last week of the option’s life it may be only worth 5 cents.
Since the option’s theta is now only 5 cents and the investor has already
earned $1.95 in profit, it may make sense to buy that option back and sell the
following months slightly out of the money option and try to increase the theta
of the holding. In other words attempt to increase the daily income earned
through option decay.