Stock Option Collar Debunked

Even if you are new to options trading, you are probably already familiar with buying puts and calls. These are the two most basic options strategies and the ones that rookie options traders gravitate to. That makes sense. Puts and calls are low-risk and easier to understand. Buy a put and you want to know the underlying security to go down in value. Purchase a call and you are cheering for the underlying security to rise. Either way, you are risk exposure is restricted to the premium you pay to purchase the contract. If the contract expires worthless, you lose no more than the expense of the contract.

To that end, we are definitely fans of buying puts and calls, no matter what your level of options experience is. The potential for explosive returns without the need for betting the farm on each trade is one in the investing world. But we are also fans of broadening our horizons and investing in options is one of the most beautiful places to do this. There’s literally always a way to make a profit with so many different options strategies. Let’s look in the upper 10 options strategies.

UPDATE: Stock Option Collar

Writing options means we’re sellers of an options contract. These can be risky under some circumstances, but not with covered calls. In fact, covered call writing is perhaps the most conservative options-writing strategy because the contract you write is backed by your ownership of the underlying stock.

There are several different options strategies known as spreads. One of the more basic ones is the bull call spread. In this trade, you buy calls at one strike price and then sell the same amount of calls at a higher strike price. So if you bought five Microsoft 25 calls, you might sell five Microsoft 27.50 Or 30 calls. The contracts have to get the same expiration month and underlying security for the trade to be taken into account a bull call spread. This is a bullish strategy.

The bearish cousin of the bull call is the bear put spread. Here you will buy puts at one strike price and then sell the same amount of puts at a LOWER strike price. Both strategies limit gains. However, they also limit losses.

As you can see, a lot of options strategies offer protection to investors. Another one of these trades is the protective collar. You’ll purchase an out-of-the-money put option and write (or sell) an out-of-the-money call option under the same security with a protective collar. This strategy is used by investors that have already gotten substantial appreciation from the underlying security as a way of locking in profits.

The butterfly spread is an advanced options strategy that may seem confusing to the novice options investor. In a butterfly spread, we combine bullish and bearish spreads using three different strike prices. An example of a butterfly spread would include buying one put or call at the last or highest available strike price, then purchasing two of whatever we did not purchase during the first leg at higher or lower strike prices and then one final put or call at a lower of higher strike. Let’s try to make this easy to understand. Buy one call, buy two puts, then add another call. Voila, there’s your butterfly spread.

As an example, we sell CAT company 60 may call option at USD 4.90 and we buy 60 may put option at USD 3.10 and also buy the CAT company stock at USD 61.35. The difference between the call and put option price is 4.90  3.10 = 1.80. The difference between the stock price and the option strike price is 61.35  60 = 1.35. So, the gap between the call and put option price is greater than the difference between the stock price and the option strike price. The net of both differences is our profit that is 1.80-1.35 = 0.45. If we buy one contract, our profit is 0.45 x 100 unit = USD 45. However, the committee of the transactions for this strategy is usually USD 90, depending to which broker firm service we’re using. So, we need to acquire at least three contracts in order that we may proceed to earn a profit.

Another unique options strategy that is geared more to experienced options traders is the iron condor. The iron condor is risky and complex because you simultaneously hold a long and short position in two different strangles. This is the nature of trade you need to research before randomly committing money to it.

And our final options trade that we think you need to know is another butterfly. The iron butterfly allows investors to combine a long or short straddle with the acquisition or sale of a strangle. With the iron butterfly we use both puts AND calls, not one or the other. Using out-of-the-money options is desirable to keep costs and risks to a minimum.

FAQ’s: What is the position estblished in this option?
An insider purchased a stock prior to the IPO for $10 a share. Once public, the stock runs up to $55 a share but the insider cannot sell the stock for a year. Since put and call options exist, the individual decides to construct a collar for protection from a possible decline in the price of stock. Information concerning the options is as follows: Stock Price: Put: $55 Call: $55 Market Price Put: $3.00 Call: $3.00 a) Describe the position you establish. b) Verify that the position achieves its objective by determining the profit/loss profile on the collar if the price of the stock rises to $60, remains at $55, or declines to $40.

  • Long stock is synthetically equivalent to a long call and short put. By combining this with a short call and long put, the entire position has been synthetically negated. Regardless of how high or low the stock goes, the P/L will remain constant. This is not a collar trade since a collar trade is synthetically equivalent to a bull call spread (two different strikes). This is not a box spread, which is the combination of call and put verticals at two different strikes.

  • The insider could short a call and buy a put thereby creating a synthetic futures contract to sell the stock at $55 a share regardless of how the price changes between now and when the options expire. The cost of the put is $3 but he gets $3 from the sale of the call thereby offsetting the cost of the put. If the price rises to $60 then the stock will get called away from him at $55 a share, if the stock remains at $55, he could sell the stock at the market for $55 and let both options expire worthless. If the price drops to $40, he could exercise the put option and sell the stock to the put at $55 per share. Of course, given that he would wind up paying two options commissions to go long on the put and short on the call, he would've been better off just forgetting the collar and just buy the put thereby leaving the possibility of gaining with the stock if the stock price goes up. True the put will cost him $3 but offsetting that price by selling a call isn't worth the extra commission charge.