Putting a Collar on Risk

Options have a reputation for being risky. For many people, the word “risky” carries a bad connotation because they associate risk with losing money.

Yes, when you invest you can lose money, sometimes even all your money if you are not careful. However, in the context of investing, risk simply means there’s a wide range of potential outcomes. In other words, high risk means you could lose a lot of money but you could also make a lot of money.

Moreover, it’s actually possible to use options to reduce the risk of owning stock.

Narrow Your Range

One such strategy is called a “collar.” Specifically, I will discuss a special type of collar called a zero-cost collar. Used properly, it’s a strategy that can narrow your return into a predictable range and won’t cost you a dime to protect your stock position.

Let’s say you have 100 shares of Snap (NSDQ: SNAP), trading at about $72 as of this writing. (For simplicity’s sake, round up to $72 for our calculations.) You have done very well on the stock but you also know it’s the kind of stock that could fall 20% overnight. But you also don’t want to just sell the stock outright. Let’s further say that $65 is the lowest price you are willing to sell the stock.

You could set a stop-loss order as protection, but know that there’s no guarantee you will actually get $65 if the order is triggered. An alternative is to buy a put option with a strike price of $65. This guarantees that no matter how low SNAP falls before option expiration, you will be able to exercise the option and put the stock to the counter-party for $65 a share.

Get Free Insurance

The drawback to buying a put is that it will cost you the premium. But here’s where the second leg of the zero-cost collar comes into play. As you buy the put, you also write (sell) a call against SNAP with the same expiration date. You want to cover the cost of buying the put with the premium received for selling the call. This is what “zero cost” refers to.

Let’s use the October options to illustrate. You could buy one October $65 put (expiring October 15, 2021) for $2.13. So for the cost of $213, you have insured that you will be able to sell SNAP at no worse than $65 on or before October 15.

At the same time, you can sell the October $80 call for $2.18, collecting $218. Thus, you have completely covered the cost of buying the insurance, and you actually have an extra $5.

(Note that I am using real market prices as of this writing and I am ignoring the commission cost, which should be negligible if you use a discount broker. For example, Schwab charges $0.65 per option contract.)

Selling this call means that if SNAP ends up above $80 at expiration, your 100 shares will be called away. No matter how much higher than $80 the stock is, you will only receive $80 a share. Note that theoretically, the counter-party can exercise his option to buy SNAP from you before expiration (in the case of an American option), but in practice it’s rarely ever done.

Gain or Loss, Shown in Graph

A gain/loss graph is shown below. Notice that at both ends, the graph shows what I described above. You cap your maximum loss and maximum gain. Your maximum gain occurs with the stock at $80 and your maximum loss occurs with the stock at $65.

The graph plot assumes that you hold both legs of the collar to expiration. If you close either or both of the legs before expiration, you could realize a greater gain or bigger loss than indicated in the graph, depending on how the underlying stock moves.

As the graph shows, with this zero-cost collar strategy, you know that your return will fall somewhere in the range of -$695 to $805. In percentage terms, you guarantee that your return will fall somewhere between -9.7% and +11.1 %.

The best possible scenario for you would be if SNAP ends at exactly $80. You gain $8 per share (from $72 to $80) and you get to keep the shares. If SNAP ends up above $80, then you still gain that $8 per share, but you lose shares. Your total gain is $800 + $5 = $805 (remember the net credit from the difference in premiums).

Your maximum loss would occur when SNAP ends at $65 or less. Your loss would be $7 per share (from $72 to $65). If SNAP ends at exactly $65, you will lose $7 per share (from $72 to $65) and you keep your shares. If SNAP is under $65, you still lose that $7 per share but you sell the shares at $65, above the market price. Your maximum loss would be $700 minus the $5 credit, or $695.

If SNAP is unchanged at $72, both contracts expire worthless. Your net gain would be the $5.

As long as the price of SNAP is between $65 and $80 at expiration, the formula to find the gain or loss is: (Stock Price – $72) x 100 + $5.

Not a Fit for Everyone

The collar is clearly a conservative option strategy. It’s basically a covered call with a protective put on top.

Is the collar strategy right for you? Only you can answer the question.

If you might need cash soon, and you like having a good amount of certainty about how much you will have, then a collar is a good fit. On the other hand, if you want to aggressively go after big gains, then a collar doesn’t fit that goal.

Options trading can get complex. That’s why, if you really want to master the options game, you should turn to my colleague Jim Fink.

A world renowned options expert, Jim Fink is chief investment strategist of our premium trading service, Velocity Trader.

Jim has developed four proprietary stock filters that provide advanced knowledge of when a stock price is about to rapidly accelerate. Based on this “secret” knowledge, Jim constructs trades that have consistently reaped windfalls for his followers.

Want to learn about Jim Fink’s next trades? Click here now.