Online Stockmarket Trading Update

With the big run up in the markets over the past three weeks (S&P500 up 20%) it may be time to protect those profits. Obviously the concern is that you may miss out on further upside if you sell out now, but at the same time you do not want to give back your hard earned and as yet unrealised profits.

To protect profits your options are:

1. Sell stock holding now but will miss out on any price upside.
2. Sell calls over your stock (covered call) limits upside and only gives limited protection to the downside.
3. Buy puts (protective put) protection of unrealized profits at a cost.

Combination of the Above Options (The Collar Strategy)
There is an options strategy called a collar that is designed to protect your profits. The primary concern in employing a collar is protection of profits accrued from underlying shares rather than increasing returns on the upside.

A collar can be established by holding shares of an underlying stock, purchasing a protective put and writing a covered call on that stock. The option portions of this strategy are referred to as a combination.
The collar is an option strategy which combines a covered call with a protective put:

1. Covered Call – In the covered call you agree to sell your stock at the call strike price. For this you receive a premium (at the time you sell the call). The drawback with this strategy is that you are limiting your profits to the level of the strike price of the sold call.
2. Protective Put – With the protective put you are buying protection for your holdings. For this protection you pay out a premium, which gives you the right to sell your stock holdings at the put strike price.

Market View
The collar strategy is used when market view is Neutral, following a time of market appreciation.

Aim of Collar Strategy
An investor will employ this strategy after accruing unrealised profits from the underlying shares, and wants to protect these gains with the purchase of a protective put. At the same time, the investor is willing to sell his stock at a price higher than current market price so an out-of-the-money call contract is written, covered in this case by the underlying stock.

Advantages of Using the Collar
This strategy offers the stock protection of a put. However, in return for accepting a limited upside profit potential on his underlying shares (to the call strike price), the investor writes a call contract. Because the premium received from writing the call can offset the cost of the put the investor is obtaining downside put protection at a smaller net cost than the cost of the put alone. In some cases, depending on the strike prices and the expiration month chosen, the premium received from writing the call will be more than the cost of the put.

In other words, the combination can sometimes be established for a net credit – the investor receives cash for establishing the position. The investor keeps the cash credit regardless of the price of the underlying stock when the options expire. Until the investor either exercises his put and sells the underlying stock or is assigned an exercise notice on the written call and is obligated to sell his stock, all rights of stock ownership are retained.

Before Expiration – Roll/Close Position
The combination may be closed out as a unit just as it was established as a unit. To do this, the investor enters a combination order to buy a call with the same contract and sell a put with the same contract terms, paying a net debit or receiving a net cash credit as determined by current option prices in the marketplace.

Actions at expiration:

1. If the underlying stock price is between the put and call strike prices when the options expire, the options will generally expire with no value. The investor will retain ownership of the underlying shares and can either sell them or hedge them again with new option contracts.
2. If the stock price is below the put strike price as the options expire, the put will be in-the-money and have value, while the call option will expire worthless. The investor can elect to either sell the put before the close of the market on the option’s last trading day and receive cash, or exercise the put and sell the underlying shares at the put strike price.
3. If the stock price is above the call strike price as the options expire, the sold call will be in-the-money and the investor can expect assignment to sell the underlying shares at the strike price, while the put option will expire worthless. Otherwise, if retaining ownership of the shares is now desired, the investor can close out the sold call position by purchasing a call with the same contract terms before the close of trading.

Worked Examples

1) April collar over Westpac (WBC)
You may trade a Collar over Westpac for April protected with a 1950 April Put and with profit limited with a 2050 April Call. There are three scenarios on exercise day:

i) Westpac trading above $20.50 on 23-Apr. This would provide an exercised return of 3.2%.

ii) Westpac trading below $19.50 on 23-Apr. This would result in an exercised loss of 3.2%.

iii) Westpac trading between $19.50 and $20.50 on 23-Apr. The protection would have cost you 2.0% and you can open a new collar for May (noting XDIV due in May).

Therefore you can expect returns (with your position protected for 23 days) of between 3.2% and a loss of 3.2% depending on the stock price on the exercise day (see the payoff diagram below).

Table: Returns for an April collar over WBC.

Figure: Payoff Diagram for an April collar over WBC (Source Market Analyser).

2) May collar over Westpac (WBC)

You may trade a Collar over Westpac for May protected with a 1950 May Put and with profit limited with a 2050 May Call. There are three scenarios on exercise day:

iv) Westpac trading above $20.50 on 23-Apr. This would provide an exercised return of 0.1% (excluding dividends).
v) Westpac trading below $19.50 on 23-Apr. This would result in an exercised loss of 7.7% excluding dividends).
vi) Westpac trading between $19.50 and $20.50 on 23-Apr. The protection would have cost you 5.1% and you can open a new collar for June (excluding dividends).

Therefore you can expect returns excluding dividends (with your position protected for 58 days) of between 0.1% and a loss of 7.7% depending on the stock price on the exercise day (see the payoff diagram below). Refer to the next section showing the impact of the dividend.

Table: Returns for a May collar over WBC (excluding dividend).

Figure: Payoff Diagram for a May collar over WBC (Source Market Analyser).

3) May collar over Westpac (WBC) – Sweetener Upcoming Dividend Season

Table: Returns for a May collar over WBC (including dividend).

Note: Assumption for dividend is for XDIV at 19-May-09 of 55 cents.

You may trade a Collar over Westpac for May protected with a 1950 May Put and with profit limited with a 2050 May Call. The three scenarios on exercise day are the same as before, however returns improve considerably when you include dividend.

You can expect returns including dividends (with your position protected for 58 days) of between 2.9% and a loss of 4.9% depending on the stock price on the exercise day (see the payoff diagram below).

Conclusion
The Collar Options strategy provides you with protection at a price, but if you have significant unrealised gains or want to take advantage of the upcoming dividend season this strategy can provide you with a limited risk way of holding stock positions in this volatile market environment.

By Michael Hevern