Collaring Your Year-End Profits With Options

"People need to realize what they are doing with a collar," said Matthew Shapiro, president of MWS Capital Consultants, a Chicago investment advisory business that specializes in using options to manage risk for high-net-worth investment portfolios.

"People try to get too cute and unless there is a legitimate reason for using collars or even selling calls, we advise our clients to pare down holdings by selling a portion of the existing position," he noted.

"Given the complexity and ever-changing nature of tax rules, especially as it pertains to mixed straddles and constructive sales rules," Shapiro is very reluctant to establish positions that are driven by tax considerations. Even if the strategy has merit or other advantages, he always consults with a legal and accounting professional.

But legitimate reasons exist that would suggest employing a collar rather than selling off shares of the underlying. Given the current low interest rate environment, holding shares of a company that pays a dividend may be a basic part of your investment strategy.

Another benefit is that it provides for the potential of additional gains. The advantage of using the collar over entering a "one-cancels-other" order (sell Dow at a $34.70 stop and at a limit of $39.70) is that, while the stock limit orders will be executed as soon as either price level is hit, the collar can be maintained, and the long stock held even if Dow shares trade through the price points before expiration.

At Dow's current price of $37.30, it is up about 24% this year. The company also pays an annual dividend of $1.34 a share, giving it a current yield of 3.59%. By establishing the collar described above and keeping the long stock position, you'd qualify for the next two quarterly dividend payments. The position also provides for an additional gain of $2.40 a share, or 6.4%, over the next four months. Of course it also leaves you exposed to the possibility of losing $2.60 a share, or 6.9%, during the same time period.