Two Simple Tools to Help Grow your Business in a Volatile Market - Continued
For the investor who is long a stock and feeling nervous about market direction but who, for tax or other reasons, does not want to sell a stock, a collar could be a viable strategy. Like the covered call, this strategy consists of selling a call but adds the benefit of downside protection in the form of a long put. The purchase of the put can be entirely or partially paid for by the call sale. A collar essentially keeps the stock pegged at a price between the strike price of the call and the strike price of the put.
For example, assume an investor owns 1000 shares of Exxon Mobil (XOM), does not want to sell his stock until after January 1st,
and would like to limit his downside risk below $75. The shares are trading at $80. One solution would be to buy 10 January 75 puts. With the puts trading around $4 the investor could also sell some January calls to help pay for the cost of the puts. But remember that selling the calls limits any upside in the stock above the strike of the call in exchange for t
he premium collected. In this case the investor decides to sell 10 January 85 calls at $4, which pays for the entire cost of the put. He however will not be able to participate in any upside appreciation of the stock above $85. The investor has essentially pegged the stock price of XOM between now and January expiration between $75 and $85. With the stock price at $80, our maximum profit is $5 if the stock rises to $85 or higher and our maximum loss is $5 if the stock falls to $75 or lower. Both the investor and the advisor can rest easy knowing risk has been reduced. The investor will also be entitled to receive any dividends paid between now and the January option expiration.
The collar is a nice strategy to protect a stock position from price risk without the cost of buying the put alone. However one must remember that no strategy is without cost and the collar’s “hidden” cost is the lack of participation in the stock’s appreciation above the call’s strike price. But if the concern is the downside risk, then this opportunity cost may be very well worth it.
Both covered writing and collars may impact a stock’s holding period and its tax status. Before initiating either strategy you should verify any possible tax implications. Check with your tax advisor, or, for a summary account, view Taxes and Investing: A Guide for the Individual Investor.