By Frederic Ruffy
Question: How can you protect a potentially profitable but volatile position?
Answer: An option collar
Sometimes called a hedge wrapper or a fence, the collar is considered a good starting point for new options traders because it can offer a low-risk way to participate in the price increase of an underlying future or security. While new traders might find interest in the collar strategy, more experienced traders should not overlook this strategy either.
The collar can be viewed as a combination of two familiar strategies: the covered call and the protective put. The covered call consists of buying an underlying security such as a stock or futures contract and selling call options on it. The strategist is basically giving the option buyer the right to call the security away at a specific price, known as the strike price. In exchange, the covered call writer receives a premium.
The protective put involves buying the underlying security and also buying puts. The put option gives the right to sell the stock or futures contract at a specific price. It provides protection from an adverse move in the underlying security because the put guarantees the owner the right to sell the security at a predetermined price.
With the collar, the sale of a call is used to finance the purchase of the put. The upside is limited by the strike price of the call, but the worst-case scenario occurs if the price of the underlying asset plunges and the protection comes into play. Let’s consider an example.
The strategist holds a bullish view towards the 10-year Treasury note (TY) and expects the bond to perform relatively well during the next few months. As a result, the strategist wants a position in the TY March 2007 futures contract, which is quoted at 108-08. A price target is set at 110-00.
However, with recent talk about a possible uptick in inflation by mid 2007, the strategist is also concerned about a possible correction. If, for example, the March futures contract fails to hold above 107 during the next month or so, a larger correction could ensue. In short, the strategist expects a move to 110, but a break of support at 107 triggers a sell signal.
So, rather than simply buying the March futures contract at 108-08, the strategist creates a collar using the futures contract, the March 110 call and the March 107 put. The breakeven on this collar is equal to the price of the futures contract plus the cost of the put (currently offered at 26/64), minus the premium for the call (22/64), or 108-10. While the TY is quoted in 32nds, the options are quoted in 64ths. In both cases, one point is equal to $1,000 or $406.25 a contract for the March 107 put, minus the premium from the call sale. The call is bid at 22/64, or $343.75. The breakeven is 108-10.
The right side of the chart below shows the potential profit and loss from the collar. Ideally, TY will move higher (left side of chart) towards the price target of 110 and, if so, the futures contract will probably be called at 110 near expiration, creating a profit equal to the strike price of the call minus the breakeven, or $1,687.50 per contract. On the other hand, if TY breaks through 107 and never recovers, the put can be exercised at 107, creating a loss equal to the breakeven minus the strike price, or $1,312.50 per contract. In sum, the trade allows the strategist to profit from the bullish view on the 10-year, but the losses are limited if the market turns sour.
Collars can be simple or they can be used in more advanced ways to create different risk-reward scenarios. For example, one way to modify the collar into a very bullish trade is to create it for a credit (where the call premium is greater than the put premium) and use that credit to buy an out-of-the-money call. Adjustments can also be made as the price of the underlying asset changes. For example, if the strategist expects range bound trading, the put can be sold for a profit if the contract falls to the lower end of the range. The affects of margin have also been excluded in this illustration, but will also have an important impact of the percentage return on the trade. Suffice it to say, the possibilities are almost limitless and, for that reason, the collar is a great strategy for beginners and advanced traders alike.
Frederic Ruffy is senior writer and trading strategist for options education firm Optionetics. He can be reached on the Optionetics message board at www.optionetics.com.