34 lines
2.1 KiB
Plaintext
34 lines
2.1 KiB
Plaintext
Mixing Exposure • 259
|
||
The Gist
|
||
This structure is really much simpler and has a much more straightfor -
|
||
ward investment purpose than it may seem when you look at the preceding
|
||
diagram. When people talk about “taking profits” using a covered call, the
|
||
collar is actually the strategy they should be using.
|
||
Imagine that you bought a stock some time ago and have a nice
|
||
unrealized gain on it. The stock is about where you think its likely fair
|
||
value is, but you do not want to sell it for whatever reason (e.g., it is
|
||
paying a nice dividend or you bought it less than a year ago and do not
|
||
want to be taxed on short-term capital gains or whatever). Although you
|
||
do not want to sell it, you would like to protect yourself from downside
|
||
exposure.
|
||
Y ou can do this cheaply using a collar. The collar is a covered call,
|
||
which we have already discussed, whose income subsidizes the purchase of
|
||
a protective put at some level that will allow you to keep some of the unre-
|
||
alized gains on your securities position. The band labeled “Orange” on the
|
||
diagram shows an unrealized gain (or, conversely, a potential unrealized
|
||
loss). If you buy a put that is within this orange band or above, you will be
|
||
guaranteed of making at least some realized profit on your original stock
|
||
or index investment. Depending on how much you receive for the covered
|
||
call and what strike you select for the protective put, this collar may rep-
|
||
resent completely “free” downside protection or you might even be able to
|
||
realize a net credit.
|
||
Execution
|
||
The execution of this strategy depends a great deal on personal prefer -
|
||
ence and on the individual investor’s situation. For example, an investor
|
||
can sell a short-tenor covered call and use those proceeds to buy a longer-
|
||
tenor protective put. He or she can sell the covered call ATM and buy a
|
||
protective put that is close to ATM; this means the maximum and mini-
|
||
mum potential return on the previous security purchase is in a fairly tight
|
||
band. Conversely, the investor might sell an OTM covered call and buy
|
||
a protective put that is also OTM. This would lock in a wider range of
|
||
guaranteed profits over the life of the option. |