Blog Post

boilerroom [1]

29-Jan-10

Trading Collars

Collar
A collar is an interesting strategy that is often employed by major investment banks and corporate executives. This position is made by selling a call option at one strike price and using the proceeds to purchase a put option at a lower price. The cost to the investor to make this trade, therefore, is essentially zero.

Investors who hold a large position in an underlying stock and wish to liquidate their holdings at some time in the future commonly use this type of trade. Why? Well, the collar allows them to lock in a particular sale price (in actuality, it ends up being a range between two prices) ahead of time. In other words, after implementing the collar trade, they then know the exact highest and lowest dollar amounts they could potentially receive when they sell their underlying stock. Speculators do not commonly make this type of trade since it is a high-risk, low-reward scenario unless you hold the underlying stock. However, if the investor already owns the underlying stock, then the trade is very low-risk and low-cost.

Example:
Judy is an executive at IBM and has recently been awarded a significant amount of IBM stock, which is currently trading at $100. She feels strongly about IBMï¿½s prospects over the next three months, but she remembers that many other people who worked at high-tech firms had the same belief in the 1990s when the Internet bubble collapsed. Most of these people lost virtually all of their investment. In this particular case, however, Judy cannot afford to lose her entire investment. On the other hand, she would also like to try to get $10 more for per share her stock, or $110.

After assessing her personal financial situation, Judy determines that she cannot afford to sell her shares for anything less than $90. To hedge her current holdings, she decides to institute a collar trade. (This trade gets its name because the position is essentially “collared” between two prices.) It is currently January, and to collar this position for three months she sells one IBM MAR 120 call for every 100 shares she owns. With the amount she receives from this sale she simultaneously buys one IBM MAR 80 put for every 100 shares that she owns (we will assume that both sides cost $5 each). Since both of these options cost the same price, the net cost of this initial trade was $0 to her. With this trade, Judy now knows that no matter what happens, she will receive an amount between $90 and $110 if she decides to sell her IBM shares when the options expire in March.

As the graph above illustrates, Judy’s total profit or loss from the combinations of these positions is limited to $10. This means that if IBM rockets up to $200, the most Judy will receive is $110. Conversely, if IBM crashes to $20, the least she will receive is $90. For an investor who is comfortable with either of the two scenarios, this is an excellent hedging strategy.