Use Options to Collar Danger Before It Strikes

Volatility seems to just keep on rocking. Just when you think there is no more room to the downside, the Nasdaq Composite Index starts to tumble once again. Money managers are scrambling to find something that works in this choppy environment.

While the overall direction in the market continues to be up, the risk to the downside continues to climb in tandem with high volatility. Is there any trading strategy that offers upside reward with no risk to the downside?

There is something out there called a collar combination that can possibly be the answer for directional reward without the directional risk of holding a stock. This strategy can be used to take advantage of volatile stocks in which the at-the-money call premiums are higher than the at-the-money put premiums.

This type of premium discrepancy is referred to as a volatility option type skew. This skew tends to drop as puts get cheaper and rise as calls get cheaper. Exploiting this skew involves simply buying low volatility and selling high volatility. A collar spread can be employed to exploit this skew at little or no risk.

The basic strategy consists of combining long stock with calls and puts. The first part of the trade would be simply buying the stock. Next, look to sell out-of-the-money calls for at least the price of the puts just bought. Depending on the stock, this can be extremely attractive. Let's look at a real-time example of a great collar-spread candidate.

Collaring Immunex The company's one-year performance

Covering the Point Spread
Expiration	Action	Option	Quantity	Price	No Margin
	Buy Stock IMNX		100	52 3/8	$5, 237.50
1/18/2002	Buy	2002 Jan 53 Put	1	19 1/4	$1,925
1/18/2002	Sell	2002 Jan 73 Call	1	19 1/2	$1,950
			NET DEBIT	52.13	$5,212.50

Figure 1 shows the price and volume chart of Immunex (IMNX), which was trading at 52 3/8 per share Wednesday, June 28. As Figure 2 shows, purchasing 100 shares would cost the trader $5,237.50. Protecting the stock would be as simple as buying the put, in this case, a 2002 January 53 leap put for 19 1/4, creating a debit of $1,925. Selling the 2002 January 73 leap calls, which are trading at 19 1/2 and will garner a credit of $1,950, can help pay for the put.

Total cost of the combined trade is $5,212.50. This combination of puts and calls against the stock accomplishes the need for protection on the downside, but it also allows for continued profit up to the strike price of the call sold. The only negative of a collar strategy is that the profits are limited if the stock continues up past the call's strike. In a margin account, this trade would be about half the cost. It gets even better if your broker allows margin on 75% of the cost of the leap . The best and worst case scenarios break down like this:

Worst and Best Scenarios
Net Worst-Case Cash Flow	$87.50
% Return/Worst Case	1.88%
% Return/Worst Case Annualized	1.08%
Net Best-Case Cash Flow	$2,087.50
% Return/Best Case	40.05%
% Return/Best Case Annualized	25.71%

Exiting the Collar Spread

If Immunex rose to 73, the puts would expire worthless and the calls would be assigned. This would close out the stock position, leaving the trader with the maximum 20 points plus the slight credit on the trade. In a cash account, this would be $2,087 before commissions, or just over a 40% return. Because the trade may last longer than a year, the annualized return is just over 25%. If the stock were to drop to 50, the calls would expire worthless and the trader would merely have to exercise his put option to cover the falling stock. Once again, after the position is closed out, a profit of $87.50 would remain. That would amount out to a 1.68% return, or 1.08% annualized.

Collar trades do not come without considerations. First, they are not that easy to find in times of low volatility. Usually, however, there is at least one sector that will show this type of call/put skewing. A second consideration may be that the bid-offer spreads might be so wide, that after getting filled, your return on investment could drop substantially. But if the timing and placement are right, a collar can go a long way toward giving an investor a good night's sleep, even in these dangerous times.

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