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The Collar: Volatility Protection

Take a stock that could be considered “volatile”: Open Text Corporation (OTC), a Waterloo, Ontario-based software manufacturer. Chart 1 shows the price movement of this stock over the past 12 months: a low of $37.13 in September 2009, a high of $51.92 in February 2010 and, just recently, on July 2, 2010, a low of $39.01. In addition, the stock gapped up on February 4, 2010 and gapped down on April 29, 2010, followed in May by a move to the upside of the same magnitude. A passive investor who bought shares of OTC on July 20, 2009 and sold them one year later would have made a profit of $1.46 per share.

Chart 1 – Open Text Corporation (OTC) July 2009 to July 2010

The stock is attractive because it moves a lot in the very short term but, like a bucking bronco, it is difficult to ride.

With this type of stock, investors should be more concerned about the risk of loss – which can be considerable – than the potential gain which, even in the short term and the very short term, seems very real. In other words, it would be good if we could reduce the stock's volatility, even if it limits the potential gain.

To achieve this result, we can apply an option strategy called a “collar” , which enables us to limit losses and profits over a given period – usually a short period such as one month.

OTC is a Canadian stock whose options trade on the Montréal exchange (www.m-x.ca). Tables 1 and 2 show the value of OTC options that expire on the third Friday of August 2010. The prices are at the close on July 20, 2010, when the stock was at $42.21.

Table 1 – Calls on OTC expiring in August 2010
Calls
Aug/36 6.10 6.55
Aug/38 4.30 4.70
Aug/40 2.72 3.05
Aug/42 1.52 1.68
Aug/44 0.67 0.79
Aug/46 0.24 0.34
Aug/48 0.06 0.17
Table 2 – Puts on OTC expiring in August 2010
Put
Aug/36 0.03 0.15
Aug/38 0.24 0.31
Aug/40 0.58 0.71
Aug/42 1.34 1.43
Aug/44 2.44 2.72
Aug/46 3.90 4.30
Aug/48 5.65 6.15

After buying 100 shares of OTC, i.e. a lot, at $42.21 each, which represents a disbursement of $4,221, we build a collar as follows:

  1. We buy an Aug/38 out-of-the-money put at $0.31 per share, which represents a disbursement of $31;
  2. We write an Aug/46 out-of-the-money call at $0.24 per share, which represents a credit of $24.

The collar in our example, excluding the shares, costs $0.07 per share ($0.31 – $0.24) or $7 per pair of options ($0.07 x 100 shares).

If we buy 1,000 shares of OTC (10 lots), we use 10 puts and 10 calls.

Collar characteristics

  • Buying a put results in a debit. Its purpose is to protect us in case the stock drops; it is price insurance that becomes fully effective when the stock reaches the strike price (in our example, $38), at the expiration of the put.
  • Writing a call results in a credit. Its purpose is to pay for all or part of the purcha
  • se of the put. In exchange for this advantage, which enables us to buy price insurance at practically no cost, the potential gain is limited if OTC rises above the strike price ($46).
  • Both options usually have the same expiration.
  • An investor who uses a collar in a given month, as in our example, may want to repeat this strategy each month, so as to always maintain control over this erratic stock, because the collar reduces volatility. Of course, as shown in Chart 2, this strategy should be used when the stock is likely to rise, so the stock's behaviour should be studied with at least one technical analysis tool. In Chart 2, this tool is the MACD (7, 27, 7).
Chart 2 – OTC shares and the MACD (7, 27, 7)

Because it costs almost nothing, a collar can also be used as long-term price insurance. Take the following example: an investor wants to protect a stock in his portfolio over a long period, say nine months, by creating a collar with options on the stock. Why seek protection for such a long period? Because an investor who has in his portfolio many shares of a stock that has increased in value will sometimes be reluctant to sell it for tax reasons. Of course, puts that expire in nine months are very costly, and the investor may not want to incur this cost. And calls with the same expiration have a high premium as well. However, the credit obtained from writing calls can considerably reduce the cost of buying puts and sometimes offset it completely.

Possible scenarios at the expiration of the options on August 20, 2010

  • If OTC shares drop to $38 or less, we lose $4.21 per share ($42.21 – $38) or $421 per lot of shares. This is our maximum loss, because if the stock drops below $38, we exercise our put option and sell our lot of OTC at $38, which is the strike price of the put. Of course, the debit of $7 per lot of OTC shares is added to the loss incurred on the shares.
  • If OTC shares rise to $46 or more, we gain $3.79 per share ($46 – $42.21) or $379 per lot of shares. This is our maximum profit, because if the stock rises above $46, the holder of the long position will exercise his call option and we will have to sell the shares at $46, i.e. the strike price. Of course, the debit of $7 per lot of OTC shares is subtracted from the profit made on the shares.
  • If OTC shares remain at $42.21,there is no profit or loss. Both options expire out of the money, with a debit of $7 per collar.

A second collar example

After buying 100 shares (a lot) of OTC at $42.21 each (total disbursement: $4,221):

  1. We buy an Aug/40 put at $0.71 per share, which represents a disbursement of $71;
  2. We write an Aug/44 call at $0.67 per share, which represents a credit of $67.

The cost of this collar is $4 per pair of options. The protection is better than in the previous case, because the strike price of the put ($40) is only $2.21 below the price of the stock.

However, the strike price of the call ($44) is only $1.79 above the price of the stock. The strike price of this collar is less out of the money than the previous collar. We would build this collar if we think it is very possible that the stock will fall; we are more pessimistic than in the first example.

The asymmetric collar

The collars in the two examples above are almost perfectly symmetric, because the difference between the strike price of the call and the price of the stock is almost the same as the difference between the price of the stock and the strike price of the put. This type of situation usually results in a debit, because the call is written at the bid price and the put is purchased at the ask price.

To be sure of obtaining a credit, the collar must be asymmetric, with both options having the same expiration month. Here is an example:

After buying 100 shares (a lot) of OTC at $42.21 each (total disbursement: $4,221):

  1. We buy an Aug/38 put at $0.31 per share, which represents a disbursement of $31;
  2. We write an Aug/44 call at $0.67 per share, which represents a credit of $67.

The asymmetry comes from the fact that the difference between the strike price of the call and the price of the stock is only $1.79, whereas the difference between the price of the stock and the strike price of the put is $4.21. So the call is less out of the money than the put, and the premium credited for the call is greater than the premium debited for the put.
Apart from the shares, this asymmetric collar offers a credit of $0.36 per share ($0.67 – $0.31) or $36 per pair of options.

Possible scenarios at the expiration of the options on August 20, 2010

  • If OTC shares drop to $38 or less, we lose $4.21 per share ($42.21 – $38) or $421 per lot. Of course, the credit of $36 per lot of shares is subtracted from the loss incurred on the shares.
  • If OTC shares rise to $44 or more, we gain $1.79 per share ($44 – $42.21) or $179 per lot. This is our maximum profit, because if the stock rises above $44, the holder of the long position will exercise his call option and we will have to sell the shares at $44, i.e. the strike price. Of course, the credit of $36 per lot of OTC is added to the profit made on the shares.
  • If OTC shares remain at $42.21, there is no profit or loss. Both options expire out of the money, with a credit of $36 per collar.

Asymmetric collar characteristics

  • The potential gain is less than that of a standard, symmetric collar
  • An asymmetric collar always results in a credit
  • Ces deux options ont d’habitude la même échéance.
  • An asymmetric collar emphasizes the credit  

In a falling market

An investor who has sold short shares can use a collar strategy by buying a call – e.g. Aug/46 – and simultaneously writing an Aug/38 put. These are the same options as in the first collar example, but the positions are reversed: here, the call represents price insurance in case the stock rises, while the put acts a barrier that limits the profit potential. However, writing the put totally finances the purchase of the call, because the put premium is greater than the call premium.

1 A collar is not just a strategy for investors. The same technique is widely recommended by banks to their corporate clients to reduce interest rate risk on their loans and exchange rate risk on currencies.

2 Commissions, dividends and possible margins are excluded from the examples.

3 Before its expiration, an option does not react exactly like a stock. If a stock moves up or down by one dollar, the option gains or loses less than one dollar. The correlation between the two prices is called the Delta, one of the variables that describe option behaviour. However, at the expiration of the option, the Delta is1, whether the option expires in the money, on the money (the intrinsic value of the option is then zero or close to zero) or out of the money. The correlation between the stock price and the option premium is 100% or zero.

4 The MACD (Moving Average Convergence Divergence) is a technical analysis indicator in that it involves studying price charts in order to identify trends and anticipate market moves.

The author

Charles K. Langford

Charles K. Langford

PhD, Fellow CSI

Charles K. Langford is President of Charles K. Langford, Inc, Portfolio Managers. He teaches portfolio management at School of Management (École des Sciences de la Gestion), University of Québec (Montréal). He is the author of 14 books on portfolio management, derivatives strategies and technical analysis.

Until 2007 he has been vice-president overlay risk management for Visconti Venosta Teaspoon Approach Management, Ltd. Until 1990 he was portfolio manager for Refco Futures (Canada) Ltd.

He has received a Bachelor degree from Université de Montréal, a Master degree and the PhD from McGill University (Montreal); he is Fellow of CSI (Canadian Securities Institute).