Using options to protect your portfolio is, for most people, more of a theoretical exercise than a practical application. By that I mean that most people thinkabout using puts to protect their stocks—and they might even look at a few prices in the newspaper and figure out how much it would cost to hedge themselves—but when it comes right down to it, most people consider the put cost too expensive and don’t bother buying the protection.
Especially in a bull market, an investor may feel that money spent buying puts was merely flushed down the drain. That laissez faire atti- tude could get you in trouble, however. Do you have that same per- spective on your homeowner’s insurance? It’s something akin to feeling that fire insurance is unnecessary because the house hasn’t burned down before (or recently). The comparison, admittedly, is not a direct one because a natural disaster can occur on a moment’s notice, while a decline in stock prices is usually less sudden—unless another crash were to occur—so you would have some chance to buy insurance for your stocks as prices started to fall. However, if you are sitting on large stock profits, you should take a serious look at buying protection using options.
One approach that I like that limits the cost of insurance, although it may remove some or all of your upside profit potential, is the collar. In this protection strategy, you buy an out-of-the-money put as insurance and also sell an out-of-the-money call to help finance the cost of the insurance. Thus, you have placed a sort of col- lar on your stock—you have limited downside risk, but you have lim- ited upside profit potential as well. Often, with a collar, it is assumed that you sell calls and buy puts in equal quantity. However, there is a
modification to the collar strategy that is useful because you don’t necessarily have to eliminate all of your upside profit potential.
Example:Disney (DIS) was on a strong run in 1995 but suffered a setback in late November after earnings were announced. The stock was selling at about 61, and perhaps a holder of 1,000 shares would like to lock in some of the 50 percent–plus gains generated by the stock that year. Assume that he is willing to risk 10 percent (down to 55) but wants insurance if DIS falls farther than that. The following prices exist:
DIS: 61 April 55 put: 11⁄8 April 65 call: 21⁄4
Since the call is selling for twice the price of the put, he can sell 5 April 65 calls and buy 10 April 55 puts without actually laying out any money.
Then, not only is his entire 1,000-share position protected at exactly 55, but he will make profits up to 65 on all of his shares. Even if prices rise beyond 65, he still has 500 shares that are not covered by the calls that were sold; and those 500 shares can provide upside profit potential.
This form of the collar is often a more palatable type of insurance to many investors, since there is no actual cost (in the form of a debit) for the insurance. The cost comes in the form of reduced upside profit potential. With this form of collar, however, you don’t even have to give up all of your upside profit potential, only a portion of it.
This type of collar even works for highly volatile stocks. Try looking at the option prices on the most extended stock in your portfolio, and you may find a collar that fits like a glove.
Collars can often be best constructed with long-term options (LEAPS) because of the way that the long-term options are priced in order to conform with the lognormal distribution, which is the way that stock prices behave.
Example: In 2000, Advanced Fibrecom (AFCI) wanted to hedge 5 million shares of Cisco (CSCO) that they owned. At the time, CSCO was trading at
$130 per share with a relatively high volatility of 50 percent. AFCI approached a large underwriting firm that specialized in derivatives to place a “no-cost” collar on their CSCO stock. A no-cost collaris one in which the
premium from the call exactly covers the purchase price of the put. More- over, AFCI wanted the put to have a striking price of 130; that is, there was to be no downside risk. The broker asked AFCI if they minded going out three years for the hedge; and when they said, “No problem,” the deal was structured (these were not exchange-traded options, but over-the-counter options created by the underwriting firm). The final terms of the deal may seem quite amazing, but they are in line with Black-Scholes model theoreti- cal prices for three-year options. The three-year put was bought with a strik- ing price of 130, and the three-year call was sold (completing the collar) at a striking price of 200! Yes, that’s right—a volatile stock such as this enabled AFCI not only to own a put that completely eliminated their risk for three years (during which a nasty bear market took place), but also to have the potential to see their stock appreciate by slightly more than 50 percent, if it continued to rise. This was, indeed, an excellent collar.
Individual investors can’t trade three-year options with underwrit- ers such as those in the previous example; but when LEAPS options series are first listed on the option exchanges, they have about two and a half years of life. Thus, a similar collar could be established for your own holdings if you act when the LEAPS still have plenty of life remaining in them.
Using LEAPS as Collars
It was mentioned earlier that individual investors can establish collars with listed LEAPS options that might be nearly as attractive as the previous CSCO example—the collar was established with three-year options, where the put strike was 130 and the call strike was 200 (and short-term interest rates were about 5 percent). This collar was a no-cost collar, meaning that no money was required to establish the collar (in other words, the put and the call sold for the same price). There were two factors that led to this attractive situation: (1) the relatively high volatility of the stock and (2) the length of time involved in the options.
Generally stated, the higher the volatility of the stock and the longer the time horizon involved, the greater will be the difference in the striking prices between the call and the put trading for the same
price. Conversely, if an investor were to try to establish a collar with short-term options, it is unlikely that he could find much difference at all between the striking price of the put and that of the call and still find them trading at the same price. The reason behind this is the way stock prices are distributed. Since the markets are lognormal (biased to the upside), a very long-term, out-of-the-money call can be quite expensive (and an at- or out-of-the-money put would be rela- tively cheap).
Using the Black-Scholes option pricing model, one can construct a general guideline for how far apart the striking prices of the put and the call would be for various volatilities and expiration dates.
Table 3.4 shows two possible LEAPS expiration—1.5 years and 2.5 years—and six different volatilities, ranging from 15 percent to 100 percent, assuming interest rates (90-day, T-bill rates) are 5 percent.
Lower interest rates will lower all the striking price values in the table, whereas higher interest rates would result in higher striking prices in all cases.
Perhaps the table can best be explained by referring to the previ- ous example in CSCO. In that case, the stock and the put strike were equal—130. The call that paid for the put had a striking price of 200, so the call strike was 54 percent higher than the put strike. In Table 3.4, it is assumed that the put strike and the stock price are both 100, so then the call strike can be viewed as a percentageof the put strike. If CSCO were in this table, it would be on the 50 per- cent volatility row, with 3 years remaining, and the call strike would be 154 (54 percent higher than the put strike). Now look at the 50 percent volatility row in Table 3.4. You can see that 2.5-year LEAPS shows the call strike as 141 (again, if the put strike is 100). So that reduction in time from 3 years down to 2.5 years lowers your poten- tial call strike from 154 (CSCO) to 141 (as in Table 3.4).
You can easily see that the longer the time remaining and the higher the volatility, the higher the call strike will be. In some cases, you may decide notto collar if you can’t get the upside potential you want. For example, suppose you are looking at a 1.5-year LEAPS collar on a stock with 30 percent volatility. Your call strike will only be 20 percent higher than your put strike. Perhaps you are unwilling to cap off your stock’s potential at a 20 percent over the next year and a half. If so, then the collar would not be your best strategy.
Table 3.4 assumes that the underlying stock pays no dividend. If it, in fact, does pay a dividend, then the call strike will be lower because the stock price will essentially be discounted by the dividend stream (i.e., the present worth of all the dividends to be paid until the option expires). Thus, if you try to collar Altria (nee Philip Morris), for example—which pays a big dividend—then you may find that you can’t even get 10 points between the strikes. The way to adjust for this is to first subtract the present worth of all the dividends from the current stock price and thenlook at the available options. This sim- ple technique will help to visualize what strike’s call will cover the put price (although that put’s strike will appear to be out of the money without having subtracted the dividend). An example may help.
Example: Assume MO is trading at 55 and pays a quarterly dividend of 60 cents. You are considering the use of 2-year LEAPS as a collar. However, when you examine the prices, you find this:
MO price: 55, in early 2004 Jan (2006) 55 put: 9 Jan (2006) 60 call: 3.50
So, not only can’t you set up a no-cost collar, but you can’t even come close! What is going on? Well, the dividend is what’s causing this, along with
Table 3.4
HIGHEST CALL STRIKE THAT PAYS FOR PUT Stock Price = Put Strike = 100 Interest Rate = 5%
Call Strike
1.5-Year 2.5-Year
Volatility (%) LEAPS LEAPS
15 117 130
30 119 134
40 120 137
50 121 141
70 124 150
100 130 170
low interest rates (at the time, T-bills rates were below 2 percent). MO is destined to pay eight dividends of 60 cents each over the 2-year period—
$4.80 in total. At the time, interest rates were very low, so the present worth of those dividends is $4.65.
To get a fairer look at things, subtract the 4.65 from the current stock price, giving you an adjusted stock price of 50.35 (55 – 4.65). Now, try to find a collar. Theseprices are now applicable:
Adjusted MO price (discounting the dividends) in early 2004: 50.65 Jan (2006) 50 put: 6
Jan (2006) 55 call: 5.5
Thus a collar can be established for a 0.50 debit. Even thisdoes not seem real attractive, but you must remember that MO is a low-volatility stock, hav- ing a volatility of just below 30 percent. If you refer to Table 3.4, the theo- retical calculations would show that you could expect the call’s strike for that low volatility over a 2-year period to be about 25 percent above the put’s strike. In real life, though, the call in this example has a striking price of 55—10 percent above the put’s strike of 50—and a small debit would be incurred for the 2-year collar in that case. The difference is the decline in interest rates. When they are as low as 2 percent, the call’s strike in this case is expected to be only about 9 percent above the put’s strike, and that’s what we see.
You might well decide notto use the collar in this case, but at least you have correctly evaluated your alternatives and can make a rational decision after having discounted the current stock price to the extent of the dividends to be paid during the life of the collar.
Since interest rates in recent years have been much lower than 5 percent, we have included Table 3.5, which is the same as Table 3.4 except for the fact that the risk-free interest rate (90-day, T-bill rate) is 2 percent in Table 3.5, whereas it is 5 percent in Table 3.4. The figures in Table 3.5 show that when interest rates are low, the collar is not nearly as attractive a strategy. The call strike is not very far above the put’s strike. It is ironic that when interest rates are low, the stock market generally does well, so the chances of the stock rising in price are actually increased—something that also argues against using the collar in this case.
Of course, as an alternative, a stock owner could merely buy puts as insurance. The low interest rates will also have lowered the price of a LEAPS put. Even so, the purchase of a put will incur a debit, which presumably is not as attractive to the stock owner as a no-cost collar would have been.
In any case, it is imperative that the stock owner understand the effect that dividends, volatility, and interest rates can have on the cost of the collar. For only then can he assess it accurately to decide if it is something he wants to use at the current time.