Limiting Investment Risk with Derivates – Collars   Leave a comment

So the RIMM position didn’t work out, but I’m still holding the stock so the show’s not over.

The ability to buy and sell put contracts in your investment account lets you employ another options strategy called a Collar. A Collar is a position in which you both sell calls against a stock and buy puts on the stock.

In a buy-write position, the short calls limit your upside potential profit on the stock. When you also buy puts (long puts, which would utilize the trade “buy to open”) on the stock, you can also limit the potential loss in the position to a fixed amount. The maximum loss occurs at the strike price of the puts you buy – regardless of the price of the stock at expiration.

In this post, I’m going to cover a May Collar that I held on Intel Corp. (INTC).

Here’s a little spreadsheet to explain the costs of each element:

You’ll notice there’s not a lot of room for profit on the position. However, there’s also no room for loss, which definitely fits the goal of not losing money 🙂

So, what happened to INTC at expiration you ask? Well, it tanked (yellow arrow is purchase, red is sale):

INTC, Yellow was purchase date, Red was sale date

At expiration, my long put position was automatically executed because it was in-the-money. Some person out there who sold puts on INTC was forced to buy my stock (assigned) at the strike price of the puts. In this case, that was $24/share for a stock that closed below $21.

This collar is not a great example of how you should properly setup a collar. You would be a lot better off, and should always try, to completely cover the cost of your long put position with the premiums received from the calls. This works primarily in situations where the stock is a bit above the price you paid for it. The reason you want to offset the cost of the puts is to avoid increasing the cost of the investment.

On the other hand, if you can limit the potential loss to $0 or a minimum profit, that’s good too. I look at a trade with 200 shares of stock and 4 contracts involved, having a total loss potential of $9.50 to be a pretty good setup.

And it worked out fine. What I lost is not bad compared to a straight long stock position, which would have been down about 11.5% on the same trading schedule.

An important thing to do when you’re setting up a collar is to look at how things work out after all of the brokerage fees are considered. Ultimately, I could have actually made a profit if it weren’t for the brokerage fees (or if they were lower). Brokerage fees add up and have a significant impact on your rate of return when you look at it on a percentage basis.

To offset this problem, you can generally just build a larger position. Had i bought 1,000 shares of stock and set this up, the impact of fees would be significantly less on a percentage basis. You should model a couple of scenarios to see what you’re comfortable with investing and what kinds of returns you can make. Compare these different scenarios among different stocks and you’ll find that some stocks are better than others – primarily relating to their overall volatility.


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