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Option Collar
By Lawrence G. McMillan

This article was originally published in The Option Strategist Newsletter Volume 3, No. 23 on December 8, 1994. 

We have written a few articles about collars this year, but another one is appropriate because it is a strategy that can give one peace of mind in a market like this.

To review, a collar consists of long stock, a long out-ofthe- money put, and a short out-of-the-money call. The resulting position has limited risk, because of the ownership of the put. It also has limited profit potential, because of the presence of the short call. In general, investors don’t like to pay a lot of cash out of pocket for the put/call combo that sits on top of the stock. In fact, a “no-cost collar” is one in which the price of the call is equal to or greater than the price of the put when the position is established.

If one wants to establish a no-cost collar, it is usually best to use longer-term LEAPS options, for their pricing structure is more conducive to the objective of the call selling for a higher price than the put.

However, in many cases, a no-cost collar cannot be established at face value. Either there aren’t long-term LEAPS to use, or for other reasons, there aren’t any out-ofthe- money calls that can cover the cost of an out-of-themoney put.

In some cases, this problem is caused by the dividend in the underlying stock. A high dividend-paying stock has what appear to be expensive puts and cheap calls. That is because listed options don’t include the dividend. So to price such an option, one first discounts the stock price by the amount of the dividend to be paid during the life of the option, and then calculates “fair value.” Proper option modeling software takes this into account.

A trader looking to establish a collar might want to consider using the dividend to “finance” the collar. In other words, if you feel you need protection but are concerned with the cost of the collar you would need to buy, it may help to allocate the upcoming common stock dividends as part of the entire package.
Let’s look at an example using Exxon (XOM).

 XOM: 68
 Jan (‘11) 60 put: 12.55 offered
 Jan (‘11) 80 call: 9.35 bid
 Dividend: 0.40 per quarter

The above option prices are the worst extremes of the bidasked spread. It may often be possible to get an execution in the “middle” somewhere, but we will use the extremes for this example.

Using the 60 strike for the put means that you are risking about 12% from the current stock price – an acceptable risk for most investors. Having established that strike, what call can be sold to cover the cost of that put? The Jan (‘11) 70 calls are 12.30 bid, but that doesn’t allow for much upside appreciation at all, so most investors would reject that call sale. The 80 strike might be more acceptable in terms of allowing for some upside appreciation. However, as you see, a collar involving that strike costs 3.20 debit to establish. For most, that is not acceptable.

However, what if one were to consider his dividend stream as part of the payment for the put? In other words, XOM will pay $3.60 in dividends through January, 2011. The present worth of that is about $3.50 at today’s low interest rates. That is slightly more than the debit required to establish the example collar above.

Thus, this is still a “no-cost” collar if one considers the dividend stream as being part of the eventual payment for the option combo. True, this may be more of a psychological approach than a hard money approach, but it does help one to visualize what collars might make sense for his highdividend paying stocks, especially if he feels an urgent need to protect them from a major price decline.


This article was originally published in The Option Strategist Newsletter Volume 17, No. 19 on October 10, 2008.  

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