Collars are a way of protecting stocks that an investor would like to hold. In the uncertainty of the current market, investors who feel the market is bottoming and might want to buy stock but still hedge their positions can utilize a collar to protect their investment.
A collar uses a long at-the-money put and short out-of-the-money call to protect a long position in a stock holding. The goal of the protection is to allow the investor to continue to take advantage of any (further) upside movement for the stock while protecting against loss in the event of unexpected downside. The way this works is as follows:
Example: An investor feels that Satyam is consolidating and may go up. He enters into a Collar:
(Note: RS stands for Rupees)
(ATM stands for At The Money, and OTM for Out Of Money).
Buy 1200 shares SATYAM at RS 264
Buy 1 ATM put at 260 strike for RS 6 (LONG PUT)
Sell 1 OTM call at 280 strike for RS 4 (SHORT CALL)
Risk is RS 6 to make RS 14.
Risk is calculated by subtracting the cost of the put from the premium of the call—in this case, a net debit of RS 2. (We pay to buy the PUT and we receive money when we sell the Call.) Since the put will provide protection from RS 260 downwards, we will also lose RS 4 in the shares purchased before we get protection.
The maximum upside this trade now has is RS 16. We buy at 264 and a call is sold at 280. The maximum profit is 280 minus 264 = RS 16.
The cost of the Collar is RS 6 and this cost should be deducted from the maximum gain of RS 16. The Net gain is RS 16 minus RS 6 = RS 10.
I repeat, the maximum loss is = RS 6.
For one contract of Satyam, the loss is 1200 shares multiplied by RS 2 = RS 7200. Commissions will have to be considered separately.
Spreads: The actual bid and offer prices for the two options we are considering are given below. Rates as on close on Friday, May 3, 2002.
Satyam PUT 260: Bid 5.85 and Ask 6.20
Satyam CALL 280: Bid 4.25 and Ask 4.50
The Bid is the price that a buyer is prepared to pay. If you are selling then you will receive the bid price. The Ask is the price at which a seller is prepared to sell. If you are buying then you will have to pay this price.
Since a collar is usually a debit spread, you should not have to put up margin money. However you should check with your broker to find out if they require margin.
What is the benefit of looking at collars in the current market?
The Nifty has retraced from its highs and has reached a support level. Therefore there may be a possibility that the market may rally from here.
An investor who feels that the market is bottoming out and wants to buy stocks may use collars to protect his risk.
A trader who is not sure about market direction may set up a collar to benefit if the market rises. He has limited losses if the market falls.
Investment. This trade requires investments. You have to buy 1200 shares of Satyam. Most brokers and banks will give you 50% financing on the cost. Instead of buying 1200 shares you can buy ONE Satyam futures. Margin on futures will be less. But you also have to pay a premium and your potential profits are reduced by this amount. If your broker requires margin on the Call sold, then you also have to deposit this amount. The margin is usually 20% of the cost.
There is no such thing as a free lunch. Traders must now be prepared to put in money to make gains.
As usual, be careful.
