7 Minute Read

Options Theory: Adding Color to a Collar

April 26, 2018

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I’ve traded through about 48 different earnings seasons and for the lion’s share of those I was writing about my adventures. At this point, I’ve covered how to think about, protect against, and speculate into these quarterly events from virtually every possible angle. The challenge each time I trot out these topics is to color the commentary in such a way as to not repeat myself. It doesn’t serve you readers very well and it’s boring as can be for me.

And, remember, my intent in crafting these weekly pieces is to entertain myself. If you learn something along the way, it’s purely unintentional:)

If you need a brush-up on how to collar your stock position into earnings, take a look at my expose that was posted last quarter: Collaring Earnings.

For today, let’s talk about how to apply the benefits of a collar strategy to your portfolio. You’ll recall in my prior missive on collars (the one I just linked to!) we looked at an example on Twitter stock. Comparing the stock position before and after the collar is added provides a perfect visual to see the tactic’s primary benefit. Were I to sum it up in two words, it would be volatility reduction.

By selling an upside call and buying a downside put we limit the scope of potential outcomes. The magnitude and number of positive and negative outliers are reduced. In fact, they’re outright eradicated. In the Twitter example, our max profit was 9.1% which isn’t exactly a blowout win. On the flipside the max loss was only 7.6% which is hardly gutwrenching.

But that’s the point, the objective of the gambit! The collar is designed to contain our position, to restrict its ability to fly or die. It brings stability to a potentially unstable situation. If our emotions are tied to the magnitude of the swings in a position’s (or portfolio’s) value, then limiting those swings will, in turn, reduce the emotional toll exacted by big volatility.

Many wander, and some run headlong, into the options market to limit liability. They seek a less volatile way of capturing the lofty gains that beckon in stocks. And, perhaps no strategy better illustrates how to accomplish this feat than the collar. Through the addition of options, it turns a long stock position into what is effectively a spread trade.

So here’s how to do it with your other positions outside of earning season. Here’s the situation where I find this particularly attractive. As the markets have continued to climb to dizzying heights (I’m talking the last five years, not three months), I’ve found it increasingly challenging to put new money to work. Visions of bear markets have danced through my head, and I utterly refuse to buy ETFs like SPY, IWM, EEM and the like when a 30% to 50% drawdown could be in the cards.

Fortunately, I can create collar positions to limit (and thus, define) the risk. Do you know how much easier it is to throw $16k into IWM when I know my max downside is $2K, no matter what? The critical shift I make to the collar when I’m building it on a long-term position instead of trying to hedge into a single earnings release is to buy a long-term put and sell a series of short-term calls against it. Remember, in a conventional collar you buy a put and sell a call which expire in the same month. By splitting the months, I’m engaging in a bit of theta arbitrage. That is, buying a long-term option to reduce the negative theta while selling a short-term option to amplify the positive theta.  I suppose we could call this version a diagonalized collar.

For example, with IWM at $154 I might buy a one-year 10% OTM put (the March 2019 $139 strike) and sell an OTM call each month against the stock.

Isn’t the options market grand?

Chart Modal

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