Put Spread Stock Collar

27th October 2009

Here’s a twist on the traditional Stock Option Collar that you might find is a less expensive way to protect your investments. Since the stock market has experienced an extreme fall, and an extreme bounce, there is a good probability that it will be trading in a tighter range over the next 6 months to a year. In addition, while the current slow down in upward market momentum is likely to provide a good opportunity to add to your long positions, the fact that the economy is not out of the woods means you should do so while exercising a bit of caution.

Given that scenario, the Put Spread Stock Collar is a way you can become a cautious stock market bull. This trade is the combination of a Covered Call with a Bear Put Spread.

Here is an example with the SPY trading between 107 and 108:

Buy SPY at 107.50

Sell SPY June 120 Call

Buy SPY June 100 Put

Sell SPY June 90 Put

SPY Put Spread Stock Collar

You should be able to structure a trade similar to this for nothing more than the price of the SPY. This trade does nothing for you besides giving you peace of mind if the stock market continues to trade within a normal 1 standard deviation range of where it is when you make your purchase. That is OK, because it provides some protection if the market falls quite a bit more than that, and allows you to participate in a normal level of growth.

The bad side: your growth is limited if the market sky rockets again and your protection is limited (but much better than nothing) if the market plummets again. Do not let that get in your way though, since there is a 95% chance that the market will stay within the effective range of this trade.

What do you think?

This entry was posted on Tuesday, October 27th, 2009 at 11:47 am and is filed under Strategies. You can follow any responses to this entry through the RSS 2.0 feed. You can skip to the end and leave a response. Pinging is currently not allowed.

4 Responses to “Put Spread Stock Collar”

Allen Massey Says:
October 31st, 2009 at 11:28 am
Hello Joe,

What would be the best way to protect profits made with the recent quick increase of AAPL while still participating in the increase many analysts are predicting for AAPL?

Thanks,

Allen
Joe Says:
November 3rd, 2009 at 2:06 pm
Hi Allen,

With the recent drop in the market the increased volatility has made the price of options more expensive than just a couple of weeks ago.
Let’s look at a few alternatives for you to choose from:

1. You could just buy a put, but that would be too costly.

2. You could convert your position to a covered call, but all that would do is give you a cushion on the downside. It does not provide you any real protection.

3. You could combine the two into a stock option collar, trying to use the proceeds from selling the call to purchase the put. While this is a good start, if you are trying to do this for a low cost, your upside potential will be less than your downside protection.

4. Try the Put Spread Stock Collar I wrote about just last week.

For example, say apple is at 190:
Let’s go out 1 standard deviation to the up side, and add protection 1 standard deviation to the down side.

Sell Apr 230 Call
Buy Apr 180 Put
Sell Apr 145 Put

Assuming you already own AAPL, you should be able to place this trade for close to no cost if you structure it so that the two sold options pay for the one purchased option. Do not forget to factor in the original cost of AAPL (or the cost of AAPL to place the whole trade now) to determine your actual return on this trade. While this approach does not cover you if the stock market really goes into the tank like it did a year ago, it will provide a large cushion if the market corrects 15 – 20% while leaving room for AAPL to pick up 15% to 20% on the upside.

5. Another Strategy: The Bull Call Spread

If you really do expect AAPL to gain at least 20% in the next 6 months, this option only strategy might be right for you.
For the same amount of risk, you can place a trade the requires far less capital. This way, you do not even have to spend the money to buy AAPL.

Buy AAPL Apr 210 Call
Sell AAPL Apr 230 Call

Of course the down side of this one is AAPL going nowhere. If that happens, you lose the $1,200 you invested, but then you still have the $18,000 you did not have to spend to buy the stock in the first place.

The choice is yours!

I hope this helps.

JD
Allen Massey Says:
November 4th, 2009 at 4:46 pm
Thanks Joe,

I will try the Bull Call Spread, that sounds like a very good plan for what I expect (hope) to happen.

Thanks for the great advice!

Allen
Ahmed Says:
November 29th, 2009 at 11:33 am
The number of trades could be reduced to three by replacing the 120 covered call with a 120 short put.