Editor's note: Welcome to "Booyah Breakdown," an explanation of terms and topics Jim Cramer discusses on his "Mad Money" TV show. Feel free to ask a question if you're confused about something Cramer talks about, but please keep in mind that we do not provide advice on specific stocks.
We've been dissecting options for a few weeks now. First we
translated the lingo of option traders andgot you in the know. Then we introduced a few
basic strategies, such as a covered call and protectiveput, that could help you buy insurance on your stock's gains.
Well, for the grand finale, we'll discuss collars. A collar combines everything we've tackled thus far. To create a collar, you sell a call and buy a put on your underlying stock. Doing so allows you to protect your downside risk and still participate in some -- but not all -- of the stock's upside.
And with earnings season upon us, now is the perfect time to chat up collars. If you have a position that you think might slip because of a disappointing earnings announcement, "collaring" your gains might just be the answer.
Fix Your Collar
To create a collar, you'll need to purchase an out-of-the-money put while simultaneously writing (selling) an out-of-the-money call option.
Wait! Why do both? Why not just buy a protective put (like we discussed a few weeks ago) to limit your downside and leave your upside alone? Because it costs money to buy a put, so to finance the put purchase, you can sell a call, says Tom Boggs, an associate director of equity products at the Chicago Mercantile Exchange. Then the money you take in from the call will offset the cash you spend on the put.
Remember, when you buy an out-of-the-money put, you buy an option with a strike price that's lower than the underlying stock's market price. So that gives you the right to sell your long shares at a price somewhere below the current market value.
When you sell an out-of-the-money call, you sell an option with a strike price higher than the stock's current market price. Doing this obligates you to sell your shares when the current market value is greater than or equal to the call's strike.
By doing this, you get downside protection with the put and can defray the cost by selling the calls, but you also limit your upside if the stock rises, at least for the life of the options.
Definitely time for an example.
Back to good old
Proctor & Gamble
. Let's presume it's still hovering around $62 (to keep our examples consistent with the previous options columns), and you bought your 100 shares at $52 back in April. You're notfeeling all that giddy about the future these days but want to protect your gains and hold on to the shares.
The first thing you want to do is buy the April 60 put, which will cost you about $1.90. And since you know that each option covers 100 shares, you'll need to cough up $190 to protect 100 shares of PG.
That's the first piece of your collar. Your next step is to sell an April 65 call. We'll say you sell it for $2 apiece, or $200 for the 100 shares. So now you're up $10. (Of course, you'll owe commissions, but we're not going there.)
So you've created a vertical spread with strikes at 60 and 65, says Tom Gentile, senior vice president and chief options strategist at
Optionetics, an options education site.
Then, if the stock falls below $60, you can exercise your put. You'll be able to sell your 100 shares for $60 a share.
So your profit becomes the sale price less the purchase price plus the net gain on your options: $6,000 minus $5,200 plus $10 = $810.
If, on the flip side, the stock jumps up over $65, the option holder will want to exercise his option and buy your shares at $65.
No worries. You still made money. Your profit will again look like this: sale price less purchase price plus the net option gain: $6,500 minus $5,200 plus $10 = $1310.
Now remember, the stock was at $62 when you decided to create the collar, so your goal was to protect your $1,000 gains. So in our example, regardless of how the stock swung, you did that, for the most part, with your collar.
Taxes Can Straddle Your Collar
As fabulous as this sounds, I'd be remiss if I didn't mention the onerous tax implications of using collars. And while Cramer says you shouldn't worry about taxes when determining profits, it's important that you at least understand what might happen.
The tax folks say that a collar falls under the "straddle rules," and the tax regulations for straddles can be nutty.
You've got two big issues with the tax rules for straddles, says Rande Spiegelman, vice president of financial planning for the Schwab Center for Investment Research. First, you cannot deduct your losses if one side of your position is still open, and second, you may lose your holding period on a short-term stock.
Huh? Let's decipher the jargon.
If you have a gain in one position of your straddle (or collar) and a loss in the other, you can't recognize the loss, for income tax purposes, until you are done with both positions. So, in our example, you bought a protective put on your appreciated PG stock. If PG keeps going up and your put expires worthless, you can't take that put loss of $190 on your tax return until you sell your PG shares. That loss will then be offset by your PG gains.
In addition, you'll have holding-period issues. The moment you enter into a straddle position, like your collar, the capital gains holding period on your offsetting positions is frozen. This isn't such a big deal if you've already held the original, appreciated position for more than one year and can qualify for the lower long-term 15% capital gains rate. But if you've held the original position one year or less, not only is the holding period frozen, it starts all over again when you dispose of your offsetting position.
So don't use a collar if you're looking to protect your gains while you wait for long-term treatment.
(Ugh. This stuff is complicated, so you really need a good tax preparer to help you through the nuances.)
Still, collars are worth considering. As we enter this precarious earnings season,we could all use a little
to make us believe that everything's going to be OK.
Tracy Byrnes is an award-winning writer specializing in tax and accounting issues. As a freelancer, she has written columns for wsj.com and the New York Post and her work has appeared in SmartMoney and on CBS MarketWatch. Prior to freelancing, she spent four years as a senior writer for TheStreet.com. Before that, she was an accountant with Ernst & Young. She has a B.A. in English and economics from Lehigh University and an M.B.A. in accounting from Rutgers University. Byrnes appreciates your feedback;
to send her an email.