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The Collar Option Trade (09/04/08)

Richard W. Miller, Ph.D.

What distinguishes average traders (short-term day traders, longer-term swing traders, even longer-term investors) from the professional ones who steadily make money? One thing, the latter control their potential for catastrophic loss, the 'train wreck" scenario, if you will.  In the current market, great stocks (e.g., POT, ANR) are selling off as money flows from strong performing sectors to those less so, even though their fundamentals haven't changed (and even improved in many cases).  ANR is a good example.  Ranked a 1 by Zacks, with a 30 percent increase in this year's earnings estimate over just the last 90 days and a price-to-earnings-to-earnings growth ratio standing now at a lowly 0.04 and 0.02 over the next two years (unbelievable value at its current price), it still lost over 23 percent of its value in the last five days.  And in the process, it gave TSM the largest loss of the quarter after providing two large winning trades earlier in the quarter.  Mark my word, soon this sector will rotate back into favor, and these great stocks will quickly run much higher.

OK, even great stocks sell off for no good reason.  Let me show you how the professional protects himself from this scenario in such a volatile market.  First, let me say that this is not something that I did with ANR. I did sell Calls to hedge the position a bit, but I didn't use that income to buy catastrophic protection, i.e., to buy Puts.  Let me say, too, this the approach I'll describe is so conservative that it could be used in an IRA account.

Let's say that on 8/27/08 you bought 1,000 shares of ANR at the close for 103.2 per share ($103,200 invested in shares).  At the same time, you could have sold 10 Oct 110 Calls (given someone the right, but not the obligation, to buy your shares for 110 over the next 52 days) and received 9.17 in premium for each share.  Just taking that premium would provide an annualized 63 percent return, 118 percent return if ANR rose above 110 and was called away. 

In this risky market, one of rapid sector rotation, the professional could add downside protection by using 8.51 of the above Calls' premium instead to buy protective Puts, specifically here buying the 10 Oct 95 Puts (allowing him to sell his ANR shares at 95 over the next 52 days even if ANR's value dropped to zero).  Over the next eight days (five trading days), ANR's price fell 24.64 points, producing a loss of 15.47 (24.64 - 9.17)  when hedged by the sale of Calls.  On the other hand, if he recognized the risky environment and put on the "Collar," i.e., sold Calls and bought Puts, the loss would have been limited to 6.26, as the overall option position gained 18.38 to offset much of the share loss.

Trade Summary

Conditions: Volatile market & stock with great fundamentals that one wants to hold;

Price Drops 24.64 points in 8 days;

   Covered Call reduces loss to 15.47;

   Collar reduces loss to 6.26;

If instead, price rises 25 points in 8 days;

   Covered Call reduces gain to 15.97;

   Collar reduces gain to 7.46 (which is still a respectable 7.2 percent return)

The professional, like the tortoise, looks for the slow, steady return by controlling the catastrophic downside move on every trade.  The option collar is a good strategy if you're holding shares.