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A Collar Case Study

We are going to show how to employ a collar using JPM as a sample idea.
Author:

In

Friday's

Keepin Your Cool With Collars, we discussed the benefits of the collar strategy for long-term investors looking to acquire shares. The collar is less risky than outright stock ownership and therefore most brokers allow investors, even those with no options trading experience, to implement the strategy. It is a good starting point when entering the world of options trading. Now, let's go one step further and create a collar case study using

JPMorgan Chase

(JPM) - Get JPMorgan Chase & Co. (JPM) Report

as our underlying stock.

Recall that in the collar strategy, the strategist buys stock, buys puts and sells calls. For every 100 shares, the strategist buys one put and sells one call. Selling calls helps finance (all or part) of the puts. The put options hedge the stock. The collar is ideal for investors that want to own a stock for longer-term time frames. Other strategies, like vertical call spreads, are better for bullish short-term plays.

JPM was the subject of a bullish article in the latest issue of Barron's. According to the October 4 edition, CEO Jamie Dimon hopes to begin raising the bank's dividend in the first quarter of 2011. Meanwhile, two sell-side analysts believe JP Morgan shares could rally more than 50% over the next two years. Prior to Friday, shares had fallen in seven of eight trading sessions and gave up 7.6% The stock is up by $0.50, at $39.26, Monday morning and has added 2.6% since Thursday.

If the Barron's article is correct, the stock could be poised to move higher in the months/years ahead and now is a good time to be an owner of JPM shares. Yet, given the potential for unexpected events and further fallout in the financial industry, initiating a collar is smarter than buying and holding shares. The collar offers a hedged way to play the stock.

For the case study, we will initiate the collar in the November options and adjust the position as needed in the months ahead. JPM is a good candidate for options plays like collars, because the strike prices of the options are at one-point increments and it is a very actively traded name. The OptionsXpress option chain (below) shows some recent quotes for JPM November put and call options. With the stock at $39.25, we can initiate a November 36-42 collar for about $39.35 per share. That is, the sale of November 42 calls at $0.62 pays for the November 36 puts at $0.62.

JPMorgan Chase (JPM) Options Chain

Source: OptionsXpress

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View Chart

The collar now offers a hedged position in JPM. If the stock falls below $36.00 per share through the November expiration, we can exercise the put and sell the stock at $36.00, or a loss of 8.3%. However, we are bullish on the stock. So, we would rather see JPM move higher. The break even is the price paid per share, or $39.25. The potential upside is to $42.00, or 7%, through the November expiration. If shares are trading above $42.00 at the expiration, the calls will be assigned and the shares sold at $42.00.

However, the long-term success of collars often depends on the adjustments made along the way. As noted in Friday's Keepin Your Cool with Collars piece, there are several adjustments that can be made depending on the price action of the underlying stock. For example, if the stock stays in a range between the two strikes, the options will expire worthless and the collar can be rolled out to later months. On the other hand, if shares rally, the position can be adjusted higher to lock in profits. Finally, if shares tank, it is not always a bad thing. Puts can be closed at a profit to buy more shares and then readjust the collar. However, the key to the trade's success over the long-term is for a gradual sustained move higher. The collar is a bullish play for investors looking to own a hedged position in shares of the underlying stock.

See you Wednesday!

At the time of publication, Fred Ruffy held no positions in the stocks or issues mentioned.

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