Options Strategy: Reverse Collar or Fence

The reverse collar or fence strategy, when done without any position in the underlying, is interesting as a speculative maneuver. A collar or fence is a defensive position, taken to protect a holding from a decline while sacrificing potential profits on the upside. Holding the stock, the investor buys protective puts and sells covered calls, at different strikes and typically out of the money. Reasons to use it would be to protect gains or when investing in a high dividend stock where there is a risk the dividend might be reduced.

The reverse strategy is, to sell out of the money puts and buy out of the money calls. There would be two situations where this might make sense: 1) the stock is range bound or 2) ahead of earnings or other news that may lead to a rapid increase in share price.

Ahead of earnings – here is an example, dating back to happier days in 2007:

06/13/2007	Jabil (JBL) Circuit closed at 20.20, earnings are due 6/21/07
06/13/2007	Buy to open 8 JBLIX, JBL Sep07 22.5 Calls @ .71	(583.95)
06/13/2007	Sell to open 8 JBLUD, JBL Sep07 20 Puts @ 1.25	984.03
	Net Credit to open position	400.08
06/21/2007	Jabil Reports 3rd Quarter Results – Revenue Increases 16 %, by 6/22 shares trade as high as 23.84
06/22/2007	Sell to close 8 JBLIX, JBL Sep07 22.5 Calls @ 2.15	1,704.02
06/22/2007	Buy to close 8 JBLUD, JBL Sep07 20 Puts @ .25	(215.95)
	Net credit to close position	1,488.07
	Profit, no % computed as it is meaningless	1,888.15

This illustrates the best feature of the strategy: for a small outlay, or even a net credit, an aggressive investor can make a quick profit if he is correct in believing that earnings will be a favorable surprise. Writing puts is risky: there are those who liken it to picking up nickels in front of a steamroller. To be on the safe side, sufficient cash should be on hand to cover the put obligations if the position develops unfavorably. But it sure is fun when it works.

Short put equivalent to covered call – Some brokers may resist letting individual investors sell puts, because it can be hazardous to your financial health. From a logical point of view, a covered call is equivalent to a short put at the same strike, and could be substituted in the example above. Psychologically it is not as pleasing, perhaps because actual money must be advanced to buy the underlying shares. When considering return on investment, or evaluating risk, the equivalence should be kept in mind because it gets rid of the impression that the strategy will let you pull money out of thin air, or gamble without putting money on the table.

Ratio - There is no law that says the puts and calls have to be on a one to one ratio: an investor who prefers leverage can use higher ratios, such as the following 8X maneuver, written up here on Seeking-Alpha before MBIA (MBI) spiked upward briefly after earnings:

04/21/2009	MBI traded at 4.30 when the opening trades were made, earnings were due early in May
04/21/2009	Sell to open 10 MBIRA, MBI Jun09 5 Puts @ 1.20	1,182.47
04/21/2009	Buy to open 80 MBIFJ, MBI Jun09 7 Calls @ .15	(1,269.99)
	Net debit to open position	(87.52)
05/11/2009	MBI reports, GAAP EPS of 3.34, reality a loss of (2.45) - Stock trades as high as 8.68 in After Hours. The next day it is attacked by short-sellers.
05/12/2009	Sell to close 80 MBIFJ, MBI Jun09 7 Calls @ .95	7,529.82
05/12/2009	Buy to close 10 MBIRA, MBI Jun09 5 Puts @ .45	(467.49)
	Net credit to close position	7,062.33
	Profit	6,974.81

Profits can be ephemeral and consideration should be given to taking them promptly. Earnings may be subject to varying interpretations.

I don't do this kind of thing very often (12 or 13 times over the past 3 years) for fear of having too many puts open against me; also, appropriate situations aren't always available. Operating as a buy and hold investor, with a heavy emphasis on analyzing and evaluating individual stocks, any puts I sell I am willing to buy the stock at the strike involved and hold it for recovery, barring adverse developments in the company's fundamentals.

Loss control and risk management – Positions of this type will come to mind on volatile or controversial stocks, where earnings or other news can create large swings in share price. It is a good idea to check for special margin or maintenance requirements and understand the implications before getting involved in selling puts. Risk management for stock investors involves keeping the size within your dollar position limits treating the options as if they were shares. In the MBI example above, the 20 puts would be considered as 20(00) X 5.00 = $10,000. The point is, you may wind up owning the shares at the strike involved, so judge risk accordingly.

Options professionals may use delta to evaluate position size. I got burned that way, so again for the stock investor who uses options I recommend the more conservative approach outlined above.

Loss control consists of a willingness to take your losses and move on. If news comes out after hours and it looks like it will tank the stock, it will sometimes make sense to offset the options position by trading the shares in the after hours. A stock such as MBI is “hard to borrow,” so it may not be possible to sell it short in order to escape from a bad situation.

Market Conditions – With 20/20 hindsight, this strategy would have performed well when applied to various of the 19 Suspect Banks or other beaten down financials at the height of the crisis. If similar conditions develop in the future, it might be a useful technique for aggressive value investors or bottom fishers.

Because ahead of earnings is a natural place to apply this strategy, it is not too early to look for cases that might surprise when 2^nd quarter earning season gets underway. From there it is a matter of patience and judgment to execute at affordable prices and strikes that have a realistic chance of paying off.

Confession: Yes, there have been times when I shot myself in the foot using this strategy. It smarts.

Disclosure: Long JBL but not using the strategy described. Long MBI, same strategy, different position.

Comments

[H. T. Love:]

Another *great* article.

I happen to be working with a stock in my wife's account right now that might benefit from this down the road.

With a little careful thinking, planning, DD and luck, maybe she'll call me "sweetie" in a few months? :-)

HardToLove

May 23 10:14 AM