Search Continues for the Perfect Hedge

In two recent articles, I've explained some key facts about an option's delta and why investors need to understand it. A number of readers said they found the topic helpful, and several of them asked for more information on hedging and protective strategies. So I'll oblige.

While there's really no such thing as a perfect hedge, one of the purest means of locking in a given price (and hopefully a profit) is a collar. I discussed this position in some detail in a previous column, but I'll provide a review of how it works.

Keeping Profits

A collar, which is also known as a conversion, is the simultaneous purchase of a put and sale of a call, with both having the same strike and expiration. This can be done in conjunction with a new stock purchase, but the strategy is typically used to lock in a profit of an existing long position. Remember, this relates to the at-the-money put and call both having a 0.50 delta with a cumulative value equal to being short 100 shares.

For example, assume you own 1,000 shares of XYZ. Suppose the stock has posted a healthy gain over the past few years and is currently trading at $80. You want to lock in a minimum sale price, but for a variety of reasons you don't want to sell the actual shares at the moment.

A purchase of 10 XYZ $80 puts and the sale of 10 XYZ $80 calls would theoretically lock in a sale price of the stock at $80. The goal is to have the sale of the call finance the purchase price of the put.

Your market view and timing considerations will help determine which strikes and expirations to use. For instance, assume XYZ happens to a biotech company. The Food and Drug Administration is going to make a decision on a new drug in the next few weeks, and you want to protect against a possible unfavorable recommendation from the agency. In this case, a short-term collar (options that expire within 30 days) would be appropriate.

If, on the other hand, you're still fundamentally bullish on your XYZ holding, you might want to use longer-dated options and adjust the strike prices. If you bought 10 XYZ January 2005 $75 puts for $5 and sold 10 January 2005 $85 calls for $5, you would be expanding your maximum sale an additional $5 to $85. But you would also be lowering your minimum sale down to $75. (This isn't a collar in the strictest definition. However, you're still effectively "collaring" the sale price, only with a wider range.)