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By Lawrence G. McMillan

This article was originally published in The Option Strategist Newsletter Volume 17, No. 13 on July 11, 2008. 

The decision to set up a hedge to protect one’s stock portfolio is never an easy one. When times are good and stocks are rising, investors are loathe to spend the money required to hedge their positions. When times are bad, and the market is dropping, the cost of hedging increases. However, that fact is usually understood by investors, who might not mind paying a little more for insurance once it is obvious that stocks are no longer rising, in general. However, another impediment to hedging usually surfaces at that time: an investor fears that he has waited too long, and thus doesn’t want to buy insurance right at the bottom of the market’s decline.

That is the situation facing many people today – both from a “macro” and a “micro” viewpoint (with “macro” protection, one buys index hedges against his portfolio, while with “micro” protection, one sets up hedges against each individual stock in his portfolio, using equity options.

We faced a situation like this for some of our managed accounts recently, and developed a “middle-ofthe- road” approach that might prove attractive to certain holders of large blocks of stock.

Hedges can take several forms. Here is a quick review, covering the most popular protection strategies: “Macro” approaches: 1) buy $SPX puts (or other broadbased indices), 2) buy $SPX collars1, or 3) buy $VIX calls (our preferred choice). “Micro” approaches: 1) buy puts on each individual stock, or 2) establish collars on individual stocks (our preferred choice).

Collars are very effective and can offer great peace of mind. Usually, one establishes a “no-cost” collar (the proceeds from the sale of calls covers the expense of buying the puts), so that there is no initial cash outlay. Once one has made the decision that a collar is necessary, he welcomes the downside protection (stock losses are limited to the striking price of the puts). He worries some about the upside (i.e., about the stock rising above the strike of the written call), but if the collar is established with long-term LEAPS options, that call strike can be substantially higher than the current stock price.

Before continuing, let’s spend a moment considering the poor timing of a major decision made by the OCC and the option exchanges this year in regard to the introduction of new LEAPS options. Normally, at this time of the year (May, June, and July), LEAPS on individual stocks expiring in January, 2011, would have been listed. But this year, the OCC – noting that “band width” is a problem (i.e., there are “too many” options with “too many” base symbols and strikes already listed), and noting that trading activity in such long-term options is often subdued when first listed – decided to delay the introduction of the 2011 LEAPS until September, October, and November. As luck would have it, the market has been terrible since early May, and many traders who would like to establish LEAPS collars – again, our preferred way to establish collars – do not have the availability of the best possible product (2011 LEAPS) to work with; they are forced to use 2010 LEAPS instead (and there’s a big difference between the two). It is ironic that bear markets seem to find numerous ways to make one’s life miserable; this is just one more example.

Is It Too Late?

Returning to the topic at hand, an investor faced with plummeting stocks in his portfolio might want to consider some form of hedging. But he might ask, “Is the decline almost over?” or “Isn’t the market so oversold that it has to rally now?” In my opinion, once one has made the decision to hedge – presumably because he doesn’t want to lose any more than a fixed amount in his stock position – he should not try to time the market in order to establish his hedge.

Let’s work through an example of what one might be facing. Suppose XYZ is trading at 30, and you want to establish a collar. At this point in time, the longest-term options are the Jan 2010 LEAPS, so you’ll use those:

Example: full collar
XYZ: 30
Jan (‘10) 25 put: 2.00
Jan (‘10) 40 call: 1.80

The implied volatility of the put is a bit higher than that of a call, so a no-cost collar can’t be established. Now, you might say, “What’s 20 cents?” But if this is a 10,000 share position (or any large position), that cost adds up, plus commissions.

By the way, if 2011 LEAPS existed, these would
be the equivalent prices:
Jan (‘11) 25 put: 2.80
Jan (‘11) 40 call: 3.15
...and so a no-cost collar could be constructed.

But they aren’t available. So what is the investor to do? A partial collar can be considered. This is a no-cost strategy, so it provides just as much downside protection. It might limit the upside a bit more, but not necessarily so.

Let’s assume that this trader has 10,000 shares of XYZ stock (this strategy works for smaller blocks of stock, too). Furthermore, suppose the Jan 35 call is also trading, and can be sold at a price of 3.00.

Example of a partial collar:
Long 10,000 XYZ stock (currently trading at 30)
Buy 100 XYZ Jan (‘10) 25 puts @ 2.00
Sell 67 XYZ Jan (‘10) 35 calls @ 3.00

There is no cost for the hedge (the call sale premium is slightly larger than the put cost). The “problem,” if there is one is that the stock is somewhat limited above 35, whereas the “full collar” above doesn’t limit the stock until it reaches 40.

However, in the “partial collar” strategy, one has the ability to roll the calls up if that becomes necessary. The question then becomes, can 67 Jan 35 calls be rolled up to 100 Jan 40 calls for a credit, if the stock rises to 35 or higher? It turns out the answer is a qualified “yes.” Once about six months have passed, if the stock rises to 38 or slightly higher, the ratio of the Jan 35 call price to the Jan 40 call price is about 1.50, so 67 calls could be rolled up to 100 for about even money.

Moreover, if some strange upside event should occur (e.g., a hostile takeover), the “partial collar” has unlimited upside potential, so the investor could take advantage of that with at least part of his stock position. In summary, traders looking to protect their stock positions should consider the “partial collar” strategy.


This article was originally published in The Option Strategist Newsletter Volume 17, No. 13 on July 11, 2008.  

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