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Sunday, November 14, 2010

Protecting investments with a Collar

The collar is another wonderful strategy that combines stocks with options to protect investments and make some profit at times as well.

Suppose you have 100 shares of company ABC. Each share is worth $10, so you have a $1000 investment. Now, you are afraid to lose money on that stock and you buy a PUT option strike price $10 for say $2.00 ($200 for the right over 100 shares).

Now if the stock goes down to $9, you lose $1 on each share, so your initial investment would be worth $900 ($100 loss). However your put option might now be worth $3.00, that means $300 remember you have to multiply by 100 as an option contract gives you the right over 100 shares. So you haven't lost anything! Cool! The problem is that if the stock does not move anywhere, then the PUT option loses value due to time decay, while no gain on the stocks is made. Mmmmmmmm, what if we could finance the purchase of that Put with something else?

What if on top of that combo the trader sells a CALL option? The trader thinks that the stock is not going above $13 any time soon and he decides to sell a 13 strike CALL for $1.00 ($100). So if the stock goes up but does not reach $13, he would be making money on the stocks he owns, plus money for the sale of the 13 CALL option which would expire worthless.

So, the final position might have been this one:
Trader owns 100 shares of ABC at $10 ($1000)
Trader Buys a $10 strike PUT for protection $2.00 ($200)
Trader Sells a $13 strike CALL in order to pay in part the purchase of his PUT. $1.00 ($100).

Now, with a total investment of 1000 + 200 - 100 = $1100 the trader is protected to the downside, yes, he will lose less money or he could even not lose at all, he could actually make money because the Put gains if the stock goes down, and the CALL sold also yields profit in that case. At the same time if the stock goes above $10 and stays bellow $13 the trader makes money from the stocks he owns and from the CALL he sold!! The PUT loses value but it is less than what you win in total. Third case, If the stock moves beyond $13, then there is a loss in the CALL that was initially sold, but it does not hurt because there are 100 shares in possession that are benefiting from the raise in price. Awesome!! very low risk! Now, there is another case where there can be a loss, and that is if the stock goes nowhere. Let us say the stock is at $10 a month later. Both the PUT and the CALL option are worthless and expired and the trader still owns the shares. That represents $1000 in assets, so there has been a $100 dollar loss.

In order to learn more about this strategy, check out this interesting and well written article from the Tycoon Report.

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