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:

  1. Protecting a portfolio from a market fall.
  2. Generating income by selling upside potential.
  3. 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:

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:

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.
Now, if one is selling calls on one instrument and buying puts on another, it is not, in fact, a true collar. It is important to remember that if you have concerns about downside exposure to a particular holding irregardless of the movement of the overall market, the only way to protect yourself is by building a true collar with calls and puts on the same underlying security.
However, this series is about option strategies for a fully-valued market rather than option strategies for a stock whose price might collapse, and if you are looking to protect yourself from general market declines, the strategy outlined above is the most efficient.
The last point above deserves a bit of explaining. Depending on the tenors and strike prices chosen, the cost of a collar may be positive, zero, or negative (i.e., a credit collar). In general, I try to keep in mind that I’ll make more money per day by selling a relatively short-tenor call but still keep in mind my desire to lower the net cost of the index puts I’d like to buy. To give an extreme example, it is probably silly to sell call LEAPS and buy 30-day puts, but depending on your outlook, and the investment you’ve chosen to make in the downside potential of the market, there are cases where it might be justified.
Example (Pseudo-)Collar
Let’s assume we have a 100-share position in IBM IBM (trading at $187 when these data were taken) for which my original buy price was $135 per share. We are looking to buy puts on the S&P 500 SPY (trading at $169 when these data were taken) that will take us through the en
d of the year. Looking at the bid price of call options for different tenors and strikes, I see the following:
Bid Prices for Calls on IBM
Source: CBOE
Each column is a strike price at each expiration, which is listed by row.
Now, here are the ask price of some put options on the SPY expiring on Dec 30 and arranged by degrees of moneyness:
Ask Prices for Puts on SPY expiring Dec. 30, 2013
Source: CBOE
In this case, I might want to sell one contract of the 28-day calls struck at 185 on IBM (a notional value of 185*100 = $18,500) and use the $5.20 in proceeds to buy two contracts of 5% OTM puts on the SPY (a notional value of (2 * 100 * 161 = $32,200). This transaction would do the following:
  • 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
After one month’s time, I will have regained access to IBM’s upside, but I will have downside protection for two more months at a pretty. In addition, I will have generated enough cash inflow to offset most or all of the brokerage and exchange taxes. Not a bad transaction, all things considered–especially in a fully-valued market.
Example Collar
Let’s quickly compare the pseudo-collar above to an actual collar–where we sell calls and buy puts on the same shares of IBM.
Here are the call prices:
Bid Prices for Calls on IBM
Source: CBOE
And here are the put prices
Ask Prices for Puts on IBM expiring Jan. 17, 2014
Source: CBOE
If I only have 100 share of IBM stock in my portfolio, I will only be able to sell one call contract. If I wanted to make a similar choice of giving up 28 days of upside potential, I could sell one contract of the 185-strike calls and with the proceeds, buy one contract of the 6% OTM put options. This transaction would do the following:
  • 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
Because we have assumed an original buy price of $135 per share, we are guaranteed a minimum return of (175 / 135 – 1 =) 30% on our investment through mid-January of next year. For the next 28 days–until the covered calls expire–our maximum return will be (185 / 135 – 1 =) 37%, after which time, our return goes back to being unlimited.
Yes, gentle reader, you could also buy two contracts of the 9% OTM puts using the proceeds from one covered call sale. But in this case, you would be making a bearish investment in IBM to the tune of 100 shares! The only time you should make a bearish investment is when you believe shares are overvalued. And if you believe IBM’s shares are overvalued, you shouldn’t waste your time hedging your position–you should simply realize your profit!
Options for a Fully-Valued Market
The wonderful thing about options is that they allow an investor to tailor, with great flexibility and ease, the risk and return profile of their portfolio holdings. 
When markets are fully valued, options provide intelligent protection against market falls. When markets are undervalued, options allow an investor to profit more from a market rise. When markets are fearful, options provide a great income stream to intelligent investors.

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