*This article was originally published in The Option Strategist Newsletter Volume 13, No. 6 on March 25, 2004. *

Since the market has stopped going up, we are receiving requests from subscribers and other stock holders about ways to hedge stocks. One good way is a collar: buy an out-of-the-money put and sell an out-of-the-money call. This is called a “collar.” If the cost of the call more than covers the price of the put, then it’s called a “no-cost collar.” This latter approach is what most traders favor, if they use this strategy. In this article, we’ll take a specific look at this strategy – one using LEAPS options. The longer-term options give one greater protection as well as allowing for upside profit potential. We’ll also look at the effect of dividends – something that is more germane now that more stocks are paying them.

One of the best examples of a no-cost LEAPS collar arose when AFCI, which owned 5 million shares of Cisco (CSCO), hedged their entire position in February, 2000 – near the top of the market. With the stock trading at 130, the collar was established with 3-year options, where the put strike was 130 and the call strike was 200 (and short-term interest rates were about 5%). That’s right, this stock holder then had no downside risk since the striking price of the put was equal to the current stock price, and yet he had the ability to see the stock rise to 200 before it could be called away – more than 50% upside potential! This collar was a “no-cost” collar, meaning that no money was required to establish the collar (alternatively stated, the put and the call sold for the same price). There were two factors that led to this attractive situation: 1) the relatively high volatility of the stock, and 2) the length of time involved in the options.

Generally stated, the higher the volatility of the stock and the longer the time horizon involved, then the greater will be the difference in the striking prices between the call and the put trading for the same price. Conversely, if one were to try to establish a collar with short-term options, it’s unlikely that he could find much difference at all between the striking price of the put and the call, and still find them trading at the same price. The reason behind this is the way stock prices are distributed. Since the markets are lognormal (biased to the upside) a very longterm, out-of-the-money call can be quite expensive (and an at- or out-of-the-money put would be relatively cheap).

Using the Black-Scholes option pricing model, one can construct a general guideline for how far apart the striking prices of the put and the call would be, for various volatilities and expiration dates. Table 1 shows two possible LEAPS expiration – 1.5 years and 2.5 years – and six different volatilities, ranging from 15% to 100%, assuming interest rates (90-day T-Bill rates) are 5%. Lower interest rates would reduce all the striking price values in the table, whereas higher interest rates would result in higher striking prices in all cases.

Perhaps the table can best be explained by referring to the previous example in CSCO. In that case the stock and the put strike were equal – at 130. The call that paid for the put had a striking price of 200, so the call strike was 54% higher than the put strike. In Table 1, it is assumed that the put strike and stock price are both 100, so then the call strike can be viewed as a percentage of the put strike. So, if CSCO were in this table, it would be on the 50% volatility row, with 3 years remaining, and the call strike would be 154 (54% higher than the put strike). Now look at the 50% volatility row in the table. You can see that 2.5 year LEAPS shows the call strike as 140 (again, if the put strike is 100). So, that reduction in time from 3 years down to 2.5 years lowers your potential call strike from 154 (CSCO) to 140 (as in the table).

You can easily see that the longer the time remaining and the higher the volatility, then the higher the call strike will be. In some cases, you may decide not to collar if you can’t get the upside potential you want. For example, suppose you are looking at a 1.5-yr LEAPS collar on a stock with 30% volatility. Your call strike will only be 19% higher than your put strike. Perhaps you are unwilling to cap off your stock’s potential at a 19% gain over the next year and a half. If so, then the collar would not be your best strategy.

Table 1 assumes that the underlying stock pays no dividend. If it, in fact, does pay a dividend, then the call strike will be lower because the stock price will essentially be discounted by the dividend stream (i.e., the present worth of all the dividends to be paid until the option expires). Thus, if you try to collar Altria (nee Philip Morris), for example – which pays a big dividend – then you may find that you can’t even get 10 points between the strikes. The way to adjust for this is to first subtract the present worth of all the dividends from the current stock price and then look at the available options. This simple technique will help to visualize what strike’s call will cover the put price (although that put’s strike will appear to be out of the money without having subtracted the dividend). An example may help:

Since interest rates in recent years have been much lower than 5%, we have included Table 2, which is the same as Table 1, except for the fact that the risk-free interest rate (90-day T-Bill rate) is 2% in Table 2, whereas it was 5% in Table 1. The figures in Table 2 show that, when interest rates are low, the collar is not nearly as attractive of a strategy. The call strike is not very far above the put’s strike. Ironically, when interest rates are low, the stock market generally does well, so the chances of the stock rising in price are actually increased – another argument against using the collar in this case.

Of course, as an alternative, one could merely buy puts as insurance. The low interest rates will also have lowered the price of a LEAPS puts. Even so, the purchase of a put will incur a debit, which presumably is not as attractive to the stock owner as a no-cost collar would have been.

In any case, it is imperative that the stock owner understand the effect that dividends, volatility, and interest rates can have on the cost of the collar. For only then can he assess it accurately to decide if it is something he wants to use at the current time or not.

*This article was originally published in The Option Strategist Newsletter Volume 13, No. 6 on March 25, 2004. *

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