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The Collar For bullish investors who want a nice low risk, limited return strategy to use in conjunction with a long stock position, collars are a great alternative.
Protecting a Long Stock Position When the stock position is long, the collar is created by combining covered calls and protective puts. From a profitability standpoint, the collar behaves just like a bull spread. The upside potential is limited beyond the strike price of the short call while the downside is protected by the long put. The position might look like this: Long: Buy 100 shares of stock @ $50: $5,000 Between 40 and 60, the long stock behaves the same as any long stock position--it gains when the stock goes up and it loses when the stock drops. However, the maximum profit is achieved when the stock is at $60. Above 60, the profit on the stock is exactly offset by the loss on the call. On the downside, the maximum loss occurs with the stock at or below $40. There, the profit from the put offsets the loss from the stock.
*The profit/loss above does not factor in commissions, interest or tax considerations. Now let's see how the same principle can be used to protect a short stock position. Protecting a Short Stock Position
To create a bear fence, traders buy out-of-the-money calls and sell out-of-the-money puts. When these options are combined with a short stock position, the new position behaves just like a bear spread. The position might look like this: Short: Sell 100 shares of stock @ $50 Like most bearish positions, this fence makes money when the stock price drops. However, the profit potential as the stock price moves down is limited beyond the strike price of the short put while the upside loss is limited by the long call. In this case, the maximum profit is achieved when the stock is at $40. Below 40, the profit on the short stock is exactly offset by the loss on the short put. Although this might seem confusing, just remember that as the stock price drops, the short stock makes money the same way a long put would. However, in this case, the put is a short put. As a result, the short put loses money as the stock drops and exactly offsets whatever profit the short stock would realize below $40. If this is still confusing, the adjacent chart may make it more understandable. Below 40, the pink line, which represents the short put, loses value at exactly the same rate that the blue line (short stock) increases in value. The yellow line, which represents the long 60 call, has no impact on the shape of the curve below $60 because it is worthless at expiration. For this reason, the only impact the call has on the combined position is to lower the overall profitability of the position by $300 (the cost of the call). Thus, the combined position is represented by the green line which flattens at a maximum profit of $950 at a stock price of $40 or below. Without the call, the position would have a maximum profit of $1,250 on the downside. However, it would also have unlimited risk on the upside. With the call as protection if the stock rises unexpectedly, the maximum loss on the upside is limited to $1,050. This loss would occur with the stock at or above $60. Above that point, the profit from the long call (yellow line) exactly offsets the loss from the stock (blue line). Again, the combined position is represented by the green line which flattens at a maximum loss of $1,050.
*The profit/loss above does not factor in commissions, interest or tax considerations. |
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