# The collar spread trade



## Hopeful (13 November 2006)

Hi everyone, how are we today with BHP down 4%? I shorted it in the US on Friday night accidentally (too many wines) and rather than use up a valuable day trade (restricted in US for small accounts) decided to cross my fingers. Pure luck. Actually, some of my biggest winners have been trades made in error!

I've been looking into options recently and the collar trade has captured my interest, calendar spreads a close second. I love the idea of being long an asset then protecting it with a put, then selling calls to firstly pay for that put and then after than to earn income. I can't quite get my thick head around it - it seems like a great strategy. Maybe someone can tell me where I'm missing the point.

Example, buy HPQ at $40, then buy a Jan 2009 $40 put for $5.50 which gives me long-term downside protection. But the cool thing is I can now write calls on HPQ every month until 2009! I've noticed that it generally takes three months to pay for the put with three written calls on the front month depending on the stock and volitility (V) etc, but that still gives me tons of time to write puts for pure income. So even if HPQ blows up and drops 50% I'll still own them and will have the LEAP to cover the damage, and I can just keep writing calls on it. So, I don't really understand the downside very much.

One thing to note is that ideally you want to sell high V calls and buy low V put/s ie V skew, but how does one go about IDing such options without sitting for hours on end looking at option Vs. Any good software/web services that can provide that function?

BTW, really enjoying studying options - can't belive I put it off for so long. Options are way cool! Cheers.


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## wayneL (13 November 2006)

Hopeful said:
			
		

> ...buy HPQ at $40, then buy a Jan 2009 $40 put for $5.50 which gives me long-term downside protection.




Hopeful,

Just buy the Jan 2009 $40 call. Same result, less capital tied up.

As an aside, Lets say at some point the shares, drop to $32. Which calls will you sell? What will you do?

Cheers


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## Hopeful (14 November 2006)

Nice idea, Wayne. I could do that, I suppose, but then I would be liable to the call buyer for dividends, wouldn't I? Don't know how significant that would be though, negligible? Sorry, more questions than answers here! One could also just buy a deep ITM call as the asset too, but that would be less capital efficient. I guess SSFs would also be an option - maybe a preferable one as I wouldn't be liable for dividends. On the downside though, I suppose long-term SSFs have poor liquidity making entry and exit a little wee bit expensive.

And now to your question, if the asset dropped to $32 from $40 then depending on what the chart looks like I could sell the put for a $6 profit, then use that to top up on the shares. The sold calls wouldn't be worth much so I could buy those back and then start a new collar trade buy buying an ITM LEAP put again, and selling slightly OTM calls. Just keep doing that sort of thing until something goes terribly wrong - I still don't know what that might be.

Is your suggestion of just buying a LEAP call instead of a LEAP put and then selling shorter-term calls just a kind of calendar spread? Thanks for your replies as usual.


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## wayneL (14 November 2006)

Whoa!

Lets have a look at your example.

Buy HPQ at 40
Buy Jan 40 put @ 4.50

(Then sell front month call options, but we’ll leave that out for the moment)

That’s all fine. But what you have with the long stock and ATM put is a synthetic long ATM call. 

In other words you *can precisely duplicate the above position by simply buying the $40 Jan 2009 call*  @ $5.50ish. It’s exactly the same. You are not liable for dividends, you don’t receive any dividends (however this is accounted for in the call premiums) and you have outlaid one hell of a lot less capital.

The deep itm call is a different position, greek wise. 

As you are long vega with the long call (synthetically or otherwise) an ATM position is worthy of consideration at low vols, a seriously foolish proposition at high vols. This is where the deep ITM may become handy, at the high vols.

As usual, the first point of analysis is implied volatility, ESPECIALLY with very vega sensitive LEAPS.

Selling front month calls will behave like CCs in this position, providing the stock stays still or moves up (but not too much). If the stock moves down to say $32,   you would want to sell the $32.50 call. Problem here is that you now have a BEARISH diagonal spread and any upside will incur additional losses. 

In your synthetic call position (long stock long put) you will not get $6 for the put (unless you get a vol rush) and you won’t be able to “top up” on stock because you will have a nett loss. I repeat, it is the same position as a long call

I can tell you don’t have a strategy modeller yet, because these issues would be immediately apparent to you. It’s free.


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## Hopeful (14 November 2006)

_Selling front month calls will behave like CCs in this position, providing the stock stays still or moves up (but not too much). If the stock moves down to say $32, you would want to sell the $32.50 call. Problem here is that you now have a BEARISH diagonal spread and any upside will incur additional losses.
_

Assuming then that I don't bother with the put and stock, just the long call;
if stock is at 32 and you sell 32.5 call options then how will you lose if the stock goes up to 32.5? The short call will be profitable and the long LEAP call will gain as well.

_In your synthetic call position (long stock long put) you will not get $6 for the put (unless you get a vol rush) and you won’t be able to “top up” on stock because you will have a nett loss. I repeat, it is the same position as a long call_

This just shows how little I understand  . If I'm long a 40 put and the stock goes to 32 don't I have a put worth 8 intrinsic plus theta? Isn't that the point of having a put when holding stock? Furthermore, if it did go down to 32 it would be ugly for stockholders meaning options will become more expensive with the higher V that bear trends produce, so the long put would have a nice premium to sell.

_I can tell you don’t have a strategy modeller yet, because these issues would be immediately apparent to you. It’s free.
_

I've downloaded it and really need to start looking at it as you can see. It looks complicated  

How long did it take you to become a consistently profitable options trader (assuming you are)?


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## Hopeful (14 November 2006)

BTW, the Options Strategy Eval Tool isn't _free_. You can't add a new stock to analyse unless you purchase it. So, I will purchase it unless I'm mistaken. Seems like a good deal actually!


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## wayneL (14 November 2006)

Hopeful said:
			
		

> Assuming then that I don't bother with the put and stock, just the long call;
> if stock is at 32 and you sell 32.5 call options then how will you lose if the stock goes up to 32.5? The short call will be profitable and the long LEAP call will gain as well.




You will have maximum profit at 32.5. But it's all downhill from there. If the stock goes to say 36... you lose.




> This just shows how little I understand  . If I'm long a 40 put and the stock goes to 32 don't I have a put worth 8 intrinsic plus theta? Isn't that the point of having a put when holding stock? Furthermore, if it did go down to 32 it would be ugly for stockholders meaning options will become more expensive with the higher V that bear trends produce, so the long put would have a nice premium to sell.




A fast move *may* give you a vol rush. But a gap could give you a vol *crush*.... it all depends. But because you have so little gamma in a LEAP, delta will have barely moved. You will have only made about 3 bucks (very theoretically) and lost $8 on the stock. (Presuming constant IV.)



> I've downloaded it and really need to start looking at it as you can see. It looks complicated




Options are complicated. Best to get used to it:

Unconscious Incompetent ==>
Conscious Incompetent ==>
Conscious Competent ==>
Unconscious Competent!!!



> How long did it take you to become a consistently profitable options trader (assuming you are)?




I opened a small account while trading shares and blew it up in about 3 months.

Decided to find out how those MM's screwed me and learned option theory properly (found out the MM's didn't screw me, I just didn't understand options).

Second go (some time later) and now consistently profitable.



> BTW, the Options Strategy Eval Tool isn't free. You can't add a new stock to analyse unless you purchase it. So, I will purchase it unless I'm mistaken. Seems like a good deal actually!




Yes it is free, and yes you can enter new stocks manually.

The derivatives add-in @ $88 (highly recommended) is preposterously cheap and is a ridiculously small fraction of the price of comparable software.

Just take some time to learn how to use it. There are instruction videos on the site.

Good luck


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## Hopeful (15 November 2006)

_You will have maximum profit at 32.5. But it's all downhill from there. If the stock goes to say 36... you lose.
_
Yes, profit capped at 32.5, maybe 1 or 2 bucks in premium.

_A fast move may give you a vol rush. But a gap could give you a vol crush.... it all depends. But because you have so little gamma in a LEAP, delta will have barely moved. You will have only made about 3 bucks (very theoretically) and lost $8 on the stock. (Presuming constant IV.)
_
Is that why buying stock rather than a LEAP for the asset is better?

I'm here *Conscious Incompetent ==>*
, better to know that you don't know stuff all:


_Yes it is free, and yes you can enter new stocks manually._

No, I can't. It's under the "underlying assets" tab, right? Can't edit without password.

I won't hesitate to pay $88, seems like great value to me, but then I havent looked far for anything else yet.

Thanks for your comments, you're posts are always appreciated!


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## wayneL (15 November 2006)

Hopeful said:
			
		

> Is that why buying stock rather than a LEAP for the asset is better?




Not necessarilly. With the LEAP, you have lost a whole bunch less in the first instance. But the thing to remember with options is that you are trading one type of risk for another, and it pays to know *where* that risk is, and to decide whether that's acceptable.

The trick with trading options is to decide where you percieve the most risk to be, and to design a strategy to minimise that risk, accept risk where you percieve it to be least, whilst ensuring the potential reward is commensurate with said risks.

.... oh, and a Plan B  




> No, I can't. It's under the "underlying assets" tab, right? Can't edit without password.
> 
> I won't hesitate to pay $88, seems like great value to me, but then I havent looked far for anything else yet.



Hmmmm he must have changed it. Understandable I guess, that's a helluva lot of IP to give away for free.

You can still struggle by as you evaluate the software however. Just change the sample values to suit.

Good luck


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## Hopeful (19 December 2006)

I've recently entered my first collar trade. I did it because I wanted to make use of my 20k cash balance at IB, as it is half in USD and half in AUD I get almost no interest. I was happy to get a max profit on the trade of  $445 with nominal max risk of $55 (I say nominal because I'm not counting funding costs since my $ is not garnering anything anyway).

But what has since transpired has me realising there is more to the collar than first meets the eye. It appears that one can greatly increase the returns on it if it moves strongly one way or the other, if you are willing to trade it dynamically (which I most certainly am). Here's what's happened:

Dec 11

Bought 100 MA at 99.83
Bought MA 100 April Put for 9.40
Sold MA 105 April Call for 8.70

-9983-940+870=-10053

Hoadley's OET tells me my potential risk is $55 and potential reward is $455 at exp.

On the 18th of Dec (only 7 days later) MA closed at $93. If I were to exit:

Sell MA at 93.00
Sell MA 100 April Put for 12.40 (last traded)
Buy MA 105 April Call for 5.30 (last traded and bid-ask mid point)

+9300+1240-530=10010

So right now the trade is near it's max loss.

But WHAT IF I buy back the April 105 Call for a $340 profit and then sell the 100 April call? My purchased put will cover my **** all the way down to zero so this is a chance for me to make some $ by selling ATM calls!???

Buy back MA April 105 Call for 5.30
Sell MA April 100 Call for 7.00

I will get a credit of $170 and I will still have my put PLUS I will now have the chance to profit from the newly sold call if MA continues to decline. Let's say MA does keep dropping down to support at ~$75, then I could continue to buy back sold calls at a profit and write new ATM ones, I could possibly do this once at each new strike for $170 credit each time until it reaches support, that would be 5x170=$850 . Much better that the original max reward of $445!. Should it go through $75 support then I would make even more. But sooner or later it will rebound and I would have to sell MA at the sold strike of say $80, and if say MA goes back to $100 then the put would expire worthless and I would have a $20 loss on the stock or $2000 loss plus my profits on the sold calls of $850, an $1150 loss. That would suck.

How do some traders handle these situations? Do they just exit the entire collar and open a new one at lower strikes until they capture the max reward? What other ways are there to make the best of this? Am I on the right track here or am I missing something? I have checked my literature on collars but they don't mention this situation specifically, to be honest I'm  a little   like :homer: would be. Cheers.


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## sails (19 December 2006)

Hi Hopeful - have you considered rolling your puts down as well as the calls - or perhaps just rolling puts down when your chart reading skills suggests that it may have bottomed out. 

Maybe do some sums on that and see if it it improves the bottom line should MA rebound.  However, as I'm sure you know, collars are definately a neutral to bullish strategy and will usually lose money in strongly bearish conditions.

Cheers,
Margaret.


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## Hopeful (19 December 2006)

sails said:
			
		

> Hi Hopeful - have you considered rolling your puts down as well as the calls - or perhaps just rolling puts down when your chart reading skills suggests that it may have bottomed out.
> 
> Maybe do some sums on that and see if it it improves the bottom line should MA rebound.  However, as I'm sure you know, collars are definately a neutral to bullish strategy and will usually lose money in strongly bearish conditions.
> Cheers,
> Margaret.




Thanks, Margaret. If I rolled down both calls and puts that would effectively just  be an exit with a small loss then a new collar with a similar risk/reward as the original, wouldn' it? I guess then if MA keeps diving then I would take a small loss  yet again. 

If I roll down the put only then I will be capturing some profit on the put buy back and I would still be covered should it fall further. Sounds good, need to crunch the numbers on that. Cheers.


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## sails (19 December 2006)

Hopeful said:
			
		

> Thanks, Margaret. If I rolled down both calls and puts that would effectively just  be an exit with a small loss then a new collar with a similar risk/reward as the original, wouldn' it? I guess then if MA keeps diving then I would take a small loss  yet again.



Exactly - you are simply re-positioning the collar if you roll both together.  That's why it's possibly better to wait until you think it may have bottomed out to roll the puts down.  There is also the idea around that you can use the proceeds of the puts to purchase more shares, but that can also have a negative or positive outcome depending on the market.

Sometimes, just taking the original small loss if the trade is not going to plan and moving on to a better opportunitity is much better than messing around, spending hours of time and effort trying to patch up the trade!

Just giving you some food for thought!


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## wayneL (19 December 2006)

Consider a synthetic put backspread if really bearish


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## wayneL (19 December 2006)

Just re-reading this:

You've got time on your side here. You can leave the collar on to see if it recovers with limited risk. The problem with rolling down the call to your put strike is this; you have a locked position called a conversion. All you will have done is locked in your loss.

You need to roll to a different strike or roll the put strikes as well, as Margaret suggested. Alway be aware of the new payoff diagram when changing strikes, it can look different to what you imagine.

You're thinking though, that's good.

Cheers


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