Protect and Profit: How a Collar Trade Can Do Both
Like the long straddle trade – which involves traders purchasing both a call and a put on the same security, at the same strike price on the same expiration date anticipating a high-volatility event – the collar trade is often overlooked.
The long collar trade – which involves owning a chunk of stock, selling calls against that stock, and buying downside put protection for it – has a place in every investors’ playbook, even if it’s rarely called upon during the game.
In fact, the collar trade has sort of a “legendary play” if we dare call it that. Back in 1999, the dot-com boom was well on its way to becoming the dot-com bust.
One person who didn’t want to risk their winnings? Mark Cuban. In 1995, Cuban and his partner set out to build an internet content-streaming company. By 1999, Broadcast.com had successfully completed its IPO and despite being valued at 57 times sales in the deal – remember, this is the dot-com era – it was acquired by Yahoo! (YHOO) for $5.7 billion.
Cuban of course, didn’t own the company outright. But the deal had given him paper profits of more than $1 billion. In fact, the 14.6 million shares he received in the deal were trading at $95, valuing his stake at roughly $1.4 billion. Because Cuban faced a lock-up period – something us retail investors aren’t usually bound by – he needed to find a way to protect his fortunes.
The answer? A collar trade. By selling an upside call, reportedly the $205 strike, and buying the $85 downside put, the now-owner of the NBA’s Dallas Mavericks basketball team essentially limited his downside to $85 per share, while capping his upside at $205.
These options expired in three years and thanks to the hysteria surrounding tech companies in the early 2000s, the premium he collected from the calls actually offset the premium he paid for the puts.
The rest is pretty much history. In 2000, shares of Yahoo! soared to almost $240, making Cuban’s collar trade initially look short-sighted (although still very profitable). By 2002, the stock and the rest of the market had plunged, with Yahoo! dropping to $13.
Instead of Cuban’s fortune shrinking to “just” $190 million, his 14.6 million shares were protected by the $85 put options, leaving the stake valued at a whopping $1.24 billion.
A pessimist will point out that his trade actually lost him $150 million. But a rationale investor will argue that it saved him over $1 billion and that managing his downside was a prudent move given the animal spirit environment the market was in at the time.
Are there things that Cuban could have done differently to maximize his position? Hindsight is 20/20 and when reflecting back, he could have lowered the strike price of his short calls and raised the strike price of his protective put, so that he wouldn’t have lost anything on the trade.
In fact, there are a few different things he could have done. One thing he couldn’t do however, is use OptionParty’s screening and ranking products.
So Where Does That Leave Us?
Why use a collar trade? Perhaps investors want to own the stock for its dividend or other upcoming catalysts. They could also already own the stock and are simply looking to protect their stake without having to sell it.
While deploying a collar may be less common than something like a bull call spread, it certainly has its applications. Because investors are selling an upside call and buying a downside put, the trade can be put on for little or no premium at all (on the options front, anyhow). In some cases, investors can even collect a net credit, depending on the chosen strike prices.
While many investors would initially think of a collar trade as selling out-of-the-money calls, and buying out-of-the-money puts as the ideal collar trade scenario, there are other ways too. Let’s look:
First we cast as wide a net as possible, then we tighten up our criteria and quickly whittle down the very best possible trades. This task could take days or even weeks, depending on how seasoned of a trader one is. But with OptionParty’s scanning and ranking method, it only takes a few minutes.
In our trade, we looked for something a bit more on the aggressive side, (you can actually alter the ranking of the final results by adjusting how conservative or aggressive you want the trades to be).
Ultimately, the top-ranked result was our choice. In it, for every 100 shares of Netflix (NFLX) that we purchase around $129, we will sell the February $110 call and buy the February $95 put.
In this case, we are selling a deep in-the-money call, and a simultaneously buying a deep out-of-the-money put. The goal here is that we will get our stock “called” away by shorting the $110 call options, given that the stock is trading nearly $20 per share higher than the short call strike price.
By doing this, we collect about $20.75 in total credit. That essentially locks in our final selling price a few dollars per share above our cost basis near $129. When it comes to total return on our capital, the gains are not very high: Just about 1.6%.
However, the return on risk is much more attractive, at 10%. The capital at risk vs. the capital needed for the trade are much different, thanks to the long put.
Think of this trade like an in-the-money covered call. While there is a high-percentage chance the long call will finish in-the-money and the stock will be called away from the investor, there is nothing substantial protecting investors in the event of a big pullback.
This collar trade does have protection though. By purchasing the $95 put options, the investor’s losses are capped at that point. In fact, because of the credit collected, the cushion is even higher. On this trade, the maximum loss is $1,325 per unit (one unit consisting of 100 shares of stock, 1 short call at $110 and 1 long put at $90). This occurs if the stock closes below $90.
Our maximum profit is achieved so long as the underlying stock closes anywhere north of $110. According to the probabilities, there’s an 82.4% chance of that happening.
A 10% return-on-risk is pretty good, especially if one can duplicate this strategy several times throughout the year. In fact, even the 1.6% return on total capital, if replicated throughout an entire year, can quickly add up to market-beating returns.
Is a collar trade the perfect trade for all environments? No. But it certainly has its place, whether it comes in the form of in-the-money collar trades being opened, or an out-of-the-money collar trade being put on an existing stock position.