When investors get to a point where they have substantial gains in a position, they may want to start to look at protection against loss. One of the most creative low cost ways to achieve this is through an options play known as a collar trade. The trade consists of buying a put option and financing the cost of that put option with a call option that has a higher strike with the same expiration. The call option may also be sold in one of the next several expirations, depending on several factors; A) Implied Volatility between the given expirations will normally dictate the call expiration to be sold, B) the differential IV in the several strikes in question, and C) the amount of time there is leading up to expiration.

The collar can be versed out of or taken prior to expiration should the traders wish. Either part of the collar may be traded out of by selling out of the put or buying the call in. If either part of the collar is in the money at expiration, the stock will be called away, although the buyer has the choice of not exercising the right to sell the stock by choosing not to exercise the put at expiration. The short call has an obligation to deliver the shares upon assignment. Should the stock close at any price between the strikes, the exercise is not automatic and the owner should retain the shares.

Examples:

A trader buys shares of BRUN at $37, the stock trades up to $51 and settles back down to $49 five weeks prior to the quarterly earnings report. The trader is concerned that the shares may fall back if the report is negative and wants to protect the profits and have the option of staying long, the shares immediately after earnings, which are due just prior to the October expiration.
BRUN @ $49.50
Days until expiration:
Oct 13 (32 days)
Nov 13 (60 days)
Jan 14 (123days)

The October 49 put is trading for 0.91
The November 52.50 calls are trading for 0.87
The January 52.50 calls are trading for 1.54

By selling the January calls for 1.54 and purchasing the October puts for 0.91 the trader receives a credit of 0.63 and achieves his goal of protecting the shares through the earnings report and also locking in a profit of $12 per share, should the shares drop in price. In addition, he will reap the gains from buying in the calls at any price below 0.63 which is the credit received to offset the 0.50 loss in the shares when he initially put the collar trade on. In addition the trader has essentially capped out his shares at $53.15 through January should the stock trade above the short call strike of 52.50 via the credit received from the sale of that call. The trader also has the option of selling the put prior to expiration, if in fact the report occurred the week leading into expiration.

The return on the shares would be $12, if they dropped and the trader chooses to exercise the long put which essentially locks in a gain of $12 on the shares from the original purchase price of $37 per share. This represents a 32.43% profit. The return on both, the Oct 49 put and Jan 52.5 call if they expired OTM would be a 1.28% profit over a 123 day time period. Should the stock get called away above the Jan 52.5 strike call, the effective sale price would be $53.15 which is up from $49.50 price and a gain of $3.65. This is a 7.33% gain from where the shares were trading when the trade was initiated. The loss of 0.04 on the Nov call and the Oct put would be minimal and protects the trader’s profits on the stock of $11.96 per share from the original purchase price of $37 a share. This is a 32.32% gain and affords the seller some additional upside capping and a sell price of $52.46 which equates to an additional 5.97% from where the shares were, when the collar trade was put on.

In any event the trader accomplishes his goal of protecting the profits below $49 per share with the only risk exposure is 0.50 on the shares which is seemingly a small price to pay for protection while still being afforded upside gains and weathering the uncertainty of earnings reports.

Ross Barnett Terry, Contributor