Grab Your Profits by the Collar

In last week's article, I talked about protecting what you've got--"hedging" in the parlance of professional investors. The problem with hedging, you might remember, was that it was so terribly expensive. For example, just today, I replied to an OptionInvestor subscriber who wrote in asking about hedging the shares of semiconductor equipment manufacturer  Applied Materials (AMAT).

It turns out that the cost of a put option to hedge his financial exposure to Applied Materials would have been about 9.2% of the shares' market value for protection that expired in October. That percentage may not sound bad, but framing this in terms of home insurance, it would be like paying $46,000 in premium every six months to insure a $500,000 home.

But do not despair! For those of you who want some downside protection, there are a few option strategies one can use that are easier on the pocketbook. Today, we will discuss one: the collar.

A collar is made up of several so-called "legs":

1. The possession of a long stock investment in which you have an unrealized gain,
   
2. The sale of a call option on your underlying stock investment, and
   
3. The simultaneous purchase of a put option on your underlying stock, struck below the sold call.

Note that the first leg is a stock investment with an unrealized gain. Ideally, we would like to buy a stock when has a price indicative of a Morningstar Rating for stocks of 5 stars. We then would like to ride that stock up to when it has a 3-star, or even 2- or 1-star price.

The next leg in this strategy is selling a call option to overlay your stock. The careful reader will instantly realize that selling a call option to overlay a stock investment is none other than a covered call--a popular option strategy. A covered call does three things: one, generates synthetic dividend income; two, cuts the covered call seller off from the upside of a stock; and three leaves the covered call seller exposed to the downside of a stock.

Because we are left with downside exposure, we need another leg to hedge. We do this with the purchase of a protective put. This protective put cuts off your downside exposure and provides a minimum "floor" below which the value of your investment cannot fall. 

Let's look at what we've done with this collar. First and foremost, we have hedged our risk of financial loss over the duration of our collar, but in doing so, we have incurred a monetary cost. To offset this cost, we have received premium income from our covered call. Analyzed in this way, we see this strategy boils down to selling an option (the covered call) to subsidize the purchase of another option (the put protection). We receive money up front for the covered call, then turn around and use some or all of that money to buy a protective put.

I say that we turn around and use "some or all" of that money because it turns out that, depending on what option you sell and buy, you may not spend all of the covered call income you receive in buying put protection. Sometimes, you can actually receive so much premium income from the covered call that it more than covers the cost of the protective put and you end up netting money from the transaction, giving you a negative cost of insurance.

Putting a Collar to Work
Let's take a look at an example of a collar on an individual stock.  MasterCard (MA) is a good company trading for just about $326 per share as of the time of this writing. However, suppose you bought the stock in 2006 when it was trading very cheaply at $44 per share. Let's assume we own exactly 200 shares of MasterCard.

So far, we have generated a healthy profit on this investment, and indeed, that is the first crucial step in implementing a successful collar. Let's now find some options on this stock to use to build the other two legs. We go to Morningstar's option pricing pages and select a tenor (duration) for our collar. I'm going to choose a tenor about five months from now--the options expiring in January 2012.

I like to sell options "at-the-money," so I will pick a call to sell with a strike price of $325. Remember that when I am selling an option, I must sell at the bid price ($38 for this option at the time of writing). Because I own 200 shares of MasterCard, I will want to sell exactly two contracts (recall that options' contract sizes are 100 shares), and I will receive the bid price times 200, which equals $7,600, minus commissions and fees.

Now let's select some put protection. I want to keep most of what I've made on this investment, so I'm going to select a put strike that is only about 10% out-of-the-money: $295 per share. This time, I'm buying the option, so I will need to transact at the ask price, and the ask price is $17.90. Again, I'll want to match my option exposure to my stock holdings and thus buy two put contracts. My total outlay for the put option will be approximately $3,580 (200 times $17.90), plus commissions. Netting this against the money I received for the covered call, we see that we have subsidized our protection so much that we actually receive $4,020 (before commissions) and are insured for a fall of 10% or greater.

Now that we've got this collar set up, let's take a look at what we stand to win or lose. We are assuming that we bought the stock at exactly $44 per share. Let's look at the best case first. If the stock stays at this price or goes up, we will end up delivering the stock we own to the call buyer and will thus sell the shares for $325 per share. In addition, we received a total of $20.10 per share from the collar, and this cash inflow increases our effective sale price to $345.10. So we bought at $44 per share and sold at $345.10 per share, for a total period gain of 684%. Wow!

Now, let's look at the worst case. If the stock suddenly collapses, we are protected at our put strike of $295. Again, our collar increases our effective sale price to $315.10 per share, and our total-period gain turns out to be 616%. Not 684%, but still worth a "Wow!"

Some Risks to Keep in Mind
Collars are designed to reduce risk by providing downside insurance at a lower cost. Because our downside exposure is limited, you could make the case that collars are a very low-risk strategy. However, there are several risks that bear mentioning. First, the fact that you do not know precisely what your end winnings will be (for example, whether you will make your maximum 684% or your minimum 616% or somewhere in between) is a risk that you would not have to think about if you sold the stock outright. When stocks are fairly valued and you can pick up one that is undervalued, you can sell the first and buy the second. There is something very comforting about knowing immediately what your end profit is on a transaction.

The other risk is that of opportunity cost. Because a collar ends up shutting you off from the upside, if the stock appreciates above your sold call strike, you will not benefit. It is for this reason that we most like designing collars around 1- or 2-star stocks the most, on the theory that they should not have much more upside potential.

A version of this article originally appeared in the May 2011 edition of Morningstar StockInvestor, edited by Paul Larson.

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