Limited Downside Risk with Limited Upside Profit Potential
Please note: Commission, dividends, margins, taxes and other transaction charges have not been included in the following examples. However, these costs can have a significant effect on expected returns and should be considered. Because of the importance of tax considerations to all options transactions, the investor considering options should consult with his/her tax advisor as to how taxes affect the outcome of contemplated options transactions.
An investor has a portfolio of mixed stocks worth $1 million that roughly matches the composition of index XYZ. With the current level of index XYZ at 100, this investor wants to establish a collar to protect the portfolio from a market decline of 5% over the next 60 days. The investor might determine the number of collars to effect by dividing the amount to be hedged (the $1,000,000 portfolio) by the current aggregate value of index XYZ (100 x 100 multiplier = 10,000). $1,000,000 / 10,000 = 100 collars, so the investor would purchase 100 puts and simultaneously sell 100 calls. This number of contracts should be adjusted according to the beta of the portfolio's performance against XYZ if it does not track the underlying index exactly.
To establish the collar position with the downside protection needed the investor chooses an XYZ put strike price 5% below the current XYZ level of 100, or the 60-day XYZ 95 put. To pay for these puts the investor is willing to forego profit potential above 5% on the upside so the 60-day XYZ 105 call is also selected. The XYZ 95 puts are purchased for a quoted price of $0.60, or $60 per option. 100 puts are therefore bought for a total of $60 x 100 contracts = $6000. The XYZ 105 calls are sold for a quoted price of $0.80, or $80 per call. 100 of these are sold, therefore, for a total of $80 x 100 contracts = $8000.
In this case, the investor has not only covered the cost of the puts with the call premium received, but has actually taken in a net credit of $2000 ($8000 call premium received - $6000 put premium paid) for establishing this 60-day XYZ index collar. This $2000 credit is the investor's to keep no matter the outcome of this position after 60 days.
XYZ Index at 100
Buy 100 XYZ 95 Puts at $0.60
Sell 100 XYZ 105 Calls at $0.80
Consider three possible scenarios at expiration:
- XYZ closes below 95 put strike price
- XYZ closes between the strike prices of 95 and 105
- XYZ closes above 105 call strike price