Hedging Stock Investments Using Low-Risk Options Strategies - Stock Option Collar

Please note that this example is for educational purposes and uses a historical trade from April 2007

Another strategy utilized by investors is the Stock Collar. This strategy involves owning or purchasing 100 shares of a particular stock, buying a put option and selling a call option. An investor sells a call option to finance the “insurance” put option. While doing this does limit the downside, it also limits the upside potential. This strategy tends to be used less by money managers because of the possibility of missing a big positive move.

In Figure 4, the investor purchases 100 shares of Yahoo, Inc. (YHOO) on April 20, 2007, buys the July 2007 $25 put option, and sells the July 2007 $32.50 call option. From the breakdown of the trade in July 2007 at the maximum and minimum extremes, the positions could show a profit of 17.08% or a loss of 9.94%. This type of trade would be most suitable for trading a stock that an investor feels has a good probability of increasing in value, but about which he still holds some hesitations. The idea with this trade is to protect the position against strong negative moves, and instead of paying the put “insurance” premium out of pocket, the investor is simply financing that premium with a call sold for a premium. There are some money managers who use collars when trading indexes; they do this because the likelihood of an index increasing by 3% in a month is very unusual, but a drop of 5% or more is more likely.

A stock/option collar could have been used in the case of Martha Stewart. When she had received insider information that a drug was going to not be approved by the FDA, she then ordered her stockbroker to sell all of her Imclone shares. Although she was not guilty of insider trading, she was guilty of obstruction of justice, after lying to Federal investigators about her actions. Had she known that a news release was about to happen (and had not received the information from the CEO before news release), she could have purchased a collar or protective put to protect against the downside. She would have never run into the problem of selling the stock, had she used one of the options strategies introduced in this paper.

Figure 4