Warren Buffett, in a recent television interview, said that he was having a hard time finding stocks to buy these days. Carl Icahn seconded the motion a day later, saying the market was fully valued. What’s an investor to do?
While options are not magical devices that can create cheap stocks out of thin air, they can be used to tailor an investment portfolio’s risk and return profile, and this ability can be a great benefit in a fully valued market like today’s.
There are three simple option strategies that can help investors in a fully valued market:
- Protecting a portfolio from a market fall.
- Generating income by selling upside potential.
- Using the income strategy to subsidize the protection strategy.
Earlier articles have gone into detail on the first and second choices above. Today, let’s move onto my personal favorite and what I think is the best option strategy for a fully-valued market.
Collars: Subsidized Downside Protection
Each of the options we’ve discussed so far–protective puts and covered calls–have their problems. Protective puts are expensive and if not executed intelligently, can needlessly eat up a great deal of investment capital. Covered calls allow a nice income inflow, but this inflow only cushions an investor from downside shocks rather than offering true downside protection.
However, when these two strategies are joined together, the strengths of each strategy serve to offset the weaknesses of the other–providing true downside protection for cheap or free (or even for a small cash inflow).
When a covered call is paired with a protective put, the resulting strategy is called a Collar. Whatever you call it, the gist of it is that you are using the cash inflow from the sale of the call to subsidize the purchase of a protective put.
Let’s go back and look at the covered call diagram from the last article:
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| Covered Call on ABC struck at $55 / share (c) 2013, IOI, LLC |
When we use the $5 cash inflow from the sold call not to cushion our downside exposure, but rather to buy a put option that protects it, we end up being completely inoculated from large market drops. This is our representation of the risk/reward profile of a collar:
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| Collar on ABC struck at $55 and $40 / share (c) 2013, IOI, LLC |
In this diagram, we have used the $5 we received from selling the calls and bought a put struck at $40 per share. If the price paid for the puts exactly matches the inflow from the covered call, it is termed a “costless collar.” If the cost of the put is less than the cash inflow from the covered call, it is termed a ?credit collar.?
In the first case, you are getting downside protection nominally for free; in the second case, you are being nominally paid to receive downside protection. (We use the word “nominally” here in both cases because of course, there may be “opportunity cost” associated with this transaction if the stock price rises past the covered call strike price. In other words, if the stock rises over the strike price, you lose the opportunity to profit from this price movement.)
Of course, the strike prices for the sold call and the purchased put can be adjusted as the investor sees fit. In the above illustration, we have shown the call written $5 Out-of-the-Money and the put purchased $10 OTM–a $15 / share spread over which the stock can fluctuate without either of the options being ITM. Our collar gives us the security for knowing that at worst, we will receive $40 per share and, at best, we will receive $55 per share for the stock–a 33% and an 83% gain, respectively, since we have assumed that the original buy price for the stock was $30 per share.
The Intelligent Collar
Thinking back to the rules we discussed for both the covered call and the protective put, it is easy to see how to get maximum bang for one’s buck using a collar.
We know that the cheapest puts we can buy are those on indices rather than individual stocks. We also know that the most efficient strike price to sell options is ATM and that shorter tenor options have a higher per-day price.
Putting all of this together in one package, we get a picture of an intelligent collar that looks like this:
- Calls are sold on a specific security in the portfolio
- Calls are sold as close to the market price as is bearable
- Premium from the sold calls goes to buy index puts
- The put is considered an investment in the downside potential of the market, not as a safety blanket
- Tenors and strike prices should be selected based on the desired cost of protection and one’s specific market outlook.
d of the year. Looking at the bid price of call options for different tenors and strikes, I see the following:
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| Bid Prices for Calls on IBM Source: CBOE |
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| Ask Prices for Puts on SPY expiring Dec. 30, 2013 Source: CBOE |
- Generate an inflow of (($5.20 * 100) – ($4.94 * 100) =) $26 per collar
- Give up potential gains on $18,500 worth of portfolio value for one month
- Protect $32,200 worth of portfolio value for three months
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| Bid Prices for Calls on IBM Source: CBOE |
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| Ask Prices for Puts on IBM expiring Jan. 17, 2014 Source: CBOE |
- Generate an inflow of (($5.20 * 100) – ($3.50 * 100) =) $170 per collar
- Give up potential gains on $18,500 worth of portfolio value for one month
- Protect (100 * 175 =) $17,500 worth of portfolio value for three months