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
collar.

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About sellacalloption

Portfolio manager and chief option strategist for Fusion Asset Management. Professional option trader with VTrader Pro, LLC.

Posted on September 28, 2011, in Options for portfolio protection and tagged , , . Bookmark the permalink. Leave a comment.

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