Strategies

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Buying Index Collars

 

Index XYZ is above 105 call strike price at expiration
 

XYZ Index at 100
Buy 100 XYZ 95 Puts at $0.60
Sell 100 XYZ 105 Calls at $0.80

 
If XYZ closes up 5% at a level of 105, the calls would expire at-the-money, with no value, and with no assignment expected. The investor’s portfolio could be expected to see an increase in value of this 5%, but the potential upside profit on the portfolio is capped at this level.

Say index XYZ increases instead by 8% and closes above the call strike put strike price of $105 at expiration, at a level of 108. The short calls will be in-the-money and assignment can be expected. Upon assignment, the investor would be obligated to pay the cash settlement amount to one or more persons exercising XYZ 105 calls. This amount would be:
(108 index level – $105 strike price strike price) x 100 multiplier = $300 for one contract. Assignment on all 100 XYZ calls would therefore be:
$300 settlement amount x 100 contracts = $30,000. The out-of-the-money puts would expire with no value.

The expected increase in value of the portfolio, if it in fact tracks the performance of index XYZ, would be the 8% increase seen in index XYZ, or $80,000. However, the investor was originally willing to cap the portfolio’s upside profit potential at 5%, or $50,000, by writing the 100 XYZ 105 calls to finance the put purchase. With an expected $80,000 increase in portfolio value after this market rise, less the $30,000 settlement amount paid upon assignment, the investor has limited the upside gain to 5%, or $50,000. This capped portfolio profit amount could be expected if index XYZ closed at any point above the $105 call strike price at expiration.

But remember, this investor received a net credit of $2,000 when establishing the collar position. This credit is kept, and to a limited extent increases the capped profit on the portfolio to: $50,000 + $2,000 = $52,000 total. If the collar had been originally established at a net debit, this would instead reduce the capped profit potential of $50,000 by the total debit amount.

 

 
 

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