Who Should Use Equity Collars?
- an investor who is looking to limit the downside risk of a
stock position at little or no cost
- an investor who is willing to forego upside potential in
return for obtaining this downside protection
Equity collars are used by investors whose primary
concern is the downside risk of a stock position. They are willing
to place a cap on upside potential in order to limit their downside
risk at little, and sometimes no cost. Collars may be of special
interest to those investors who have one equity position that
accounts for a large proportion of their net worth, and who may not
be able to reduce the size of this position. For these investors,
low cost protection may take precedence over maintaining upside
potential.
Definition
An equity collar consists of the simultaneous
purchase of a put option, and the writing of a call option. Both
options are out-of-the-money, and usually have the same expiration
date. Most often a collar is established against an existing equity
position, with one put purchased and one call written for every 100
shares held. It is also possible to establish a collar at the same
time that an equity position is purchased.
How to Use an Equity Collar
Collars are used mostly by investors who
have accumulated a large position in a given stock (through an employee
stock purchase plan, for example) and who are primarily concerned about
the downside risk of their holdings. These investors may be reluctant to
sell their stock for a variety of reasons: the tax liability could be
substantial, or selling an employer's stock may be sending the wrong
kind of signal to management or other shareholders. These investors are
also willing to give up some of the stock's upside potential in order to
obtain the desired downside protection at little or no cost.
Please note: Commission, dividends,
margins, taxes and other transaction charges have not been included in
the following examples. However, these costs can have a significant
effect on expected returns and should be considered. Because of the
importance of tax considerations to all options transactions, the
investor considering options should consult with his/her tax advisor as
to how taxes affect the outcome of contemplated options transactions.
Example
As an example, consider an investor who has accumulated
1,000 shares of XYX stock, now trading at $44.75. This investor may be
familiar with the purchase of protective puts but may also be reluctant
to spend the amount necessary to buy put options. This could be
especially true if the desired protection is for a relatively long
period of time. If a 10-month 40 put option on XYX could be purchased
for $4.75, for example, the investor might be unwilling to pay such a
high premium.
In order to lower the net cost of the protection, the investor could
purchase 10 of the 10-month 40 puts, and, at the same time, sell 10 of
the 10-month 55 calls for $4.50. The cost of the put options can be
partially if not fully offset by the premium received from writing the
call options. If the collar could be established for no net premium,
then it would be what is commonly known as a zero-cost collar.
The investor's 10-month $40-$55 equity collar transaction would look
like this:
Consider three possible scenarios at expiration:
- XYX closes above the call strike of $55
- XYX closes below the put strike of $40
- XYX closes between $40 and $55
XYX is below $40 at expiration
If XYX is trading below $40 at expiration, the investor
will have the right to exercise the put options and sell the shares at
the strike price of $40. This represents the worst-case scenario, and
the investor will have to absorb a loss of $4.75 per share (the
difference between the stock price of $44.75 when the position initiated
and the selling price of $40) and a loss of $0.25 per share, which
represents the cost of the collar. The total downside risk, therefore,
is $5.00 per share.
Note: If, prior to expiration, the investor decides to keep the shares,
the put could be sold. The proceeds from the sale of the put would
partially offset the accrued loss on the stock.
XYX is above $55 at expiration
If XYX is trading above $55 at expiration,
it is likely that the investor will be assigned on the written $55
calls. Consequently, he will be forced to sell the XYX shares at the
strike price of $55. Remember that when call options are written against
a long stock position, an obligation to deliver those shares at the
options' strike price is being assumed. If a buyer of the same calls
decides to exercise, then the writer must deliver the shares if
assignment is received.
In establishing a collar, the obligation to deliver shares was assumed
so that the call premium could be used to partially offset the cost of
the put option. The stock being called away at $55, in this example,
represents the investor's best-case scenario. A $10.25 gain (the
exercise price of $55 minus the original price of the stock, $44.75)
will be realized less the $0.25 cost of the collar. The upside,
therefore, is limited to $10 per share.
XYX is trading between $40 and $55 at
expiration
If the price of XYX is anywhere between $40
and $55 at expiration, both the put and call options will be
out-of-the-money and will expire worthless. The investor will keep the
XYX shares, and the only cost will have been that of establishing the
collar, $0.25 per share in this example. During this period, the
investor will have retained ownership of the shares, with the ability to
vote and to receive dividends, if either applied.
Summary
An equity collar is simply the coupling
of two basic, very commonly used equity option strategies into one
with a profit & loss profile that could suit most stock investors at
some point in their investing careers. For a position in the
underlying stock, it combines the downside price protection of a
protective put in return for limited upside profit potential of a
covered call. Purchase of the out-of-the-money put can at least in
part be financed by the premium received from writing the
out-of-the-money call, resulting in a relatively small net debit for
establishing the position. Depending on the strike prices chosen and
their market prices, an equity collar may from time to time be
established at a net credit, with an investor actually taking in
money to protect underlying shares already owned. This strategy is
particularly appropriate for any investor who?s net worth lies
mainly in one large stock
