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How to Use a 'Collar'

Now that you've got covered calls down, it's time to get some protection.

Erik Kobayashi-Solomon, 11/02/2011

The more the equity markets zig and zag, the more clients are interested in protection strategies. In this article, I'll build on my previous Know-How article ("How to Write Covered Calls," June/July 2011) regarding covered calls and show how you can get cheap or free protection for holdings in a client's portfolio using a "collar."

1 Understand the Two 'Legs' of the Collar Strategy
A collar is a multipart strategy that overlays two option contracts on an underlying stock position. Each of these option "legs" is easy to understand individually, so even if explaining a complex option position to clients might seem daunting, take heart--a collar is made of two easy parts: an insurance leg and an income leg.

The insurance leg consists of buying a put option on a stock holding. A put option operates just like insurance on a car; you pay premium up front, and the counterparty agrees to pay you the difference between insured value and market value in case of an "accident." The biggest problem with financial insurance is how expensive it is--a put option on even a big, stable company like Microsoft MSFT can cost about 10% per year or more.

The income leg is simply a covered call, which I discussed in the June/July issue of Morningstar Advisor.

The two legs work together. Basically, the covered call ends up subsidizing--partially or fully--the cost of the protective put.

2 Select a Stock to Collar
A collar can be used on any asset in a client's portfolio, but the best candidate is a holding on which the client has a significant, unrealized gain and which you think doesn't have much more room to run. As an example, let's take a look at Coca-Cola KO. Assume that you have a client who bought Coca-Cola at an average price of $45 per share back in late 2008. So far, the client has received $4.34 per share in dividends, so you can think of his cost basis as being $40.66. The stock is trading at $68 now, for a 67% increase from the dividend-adjusted cost basis.

This is a terrific example of a stock to collar: a big company that may not have much more upside, but which has given its owner a nice return. The stock is yielding around 3% per annum, and the client wants to keep this income stream. With a collar, we can help protect the gains at a reduced insurance cost and hereby guarantee our client a very nice return even if the price takes a swift fall.

3 Select an Expiration
Options are contracts with definite ending dates, and when we are selling them (as we are with the covered-call leg of this strategy), we prefer to sell tenors in the six- to nine-month range. Continuing on with our Coca-Cola example, I find that there is an expiration 185 days away--just more than six months. Let's pick this one.

4 Select Strike Prices
There are two strike prices to pick: the price at which a covered-call seller agrees to deliver the stock to the call buyer and the price at which our put protection kicks in. We usually like to sell covered-call legs that are near to being at the money and see how much put protection that received premium will buy us. Right now, I see some calls struck at $72.50 selling for $1.38 per share. Looking at put prices, I see that I can buy a put struck at $57.50 for $1.19 per share (meaning that our protection pays us!).

When I buy the $57.50 put and sell the $72.50 call, I end up locking in a nice gain. This table summarizes our best and worst cases:

Worst Case
Sell Price: $57.50
Dividends/Net Premium: $0.47 + $0.19
Return: 43%

Best Case
Sell Price: $72.50
Dividends/Net Premium: $0.47 + $0.19
Return: 80%
Data as of Aug. 16, 2011

My returns stem from the difference between my buy price ($40.66 in both cases) and the respective sell prices, plus the income I receive from dividends and premiums.

Erik Kobayashi-Solomon is a market strategist with Morningstar and co-editor of Morningstar OptionInvestor. For a free two-week subscription, go to http://option.morningstar.com.

Erik Kobayashi-Solomon is a market strategist and co-editor of the Morningstar OptionInvestor newsletter. Learn more about OptionInvestor.

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