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Options: Is A Collar's Underlying Really Important?

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The collar sets up an interesting question: Does it really matter which stock you employ as part of the strategy?

In the vast majority of strategies, you are cautioned to pick stocks wisely as a first move. For example if you want to write covered calls, you should be sure you want to hold 100 shares of the underlying stock. Otherwise, the profits from covered calls might be offset by losses in declining stock value.

With the collar, there are two situations in which this issue does not matter. A collar consists of three parts: 100 shares of stock, a covered call, and a long put. For example, if you own 100 shares at $41 per share, you may sell a 42.50 call and buy a 40 put. The purpose of the collar is to set up a low-risk strategy that gives you downside protection (from the put) at no cost (because the cost of the put is offset by income from the short call).

However, a collar by itself makes little sense. It's a breakeven strategy and only the ideal situation turns out profitably. This is when the stock price remains in the middle of the two strikes so both options expire out of the money; but what's the point?

The first situation where a collar makes sense is when you own 100 shares of stock you bought well above current market value. You do not want to take the loss and you believe that eventually the stock price will rebound. A collar makes sense here because it eliminates the downside risk for little or no net cost. However, you do face the risk of the short call getting exercised if the stock price rises above its strike. In that situation, you can close the call, accept exercise, or roll the call forward to a later-expiring position.

The second situation is one in which the value or volatility of the underlying stock does not matter. Here, you focus on high-dividend stocks and volatility actually improves the outcome. The collar is opened just before ex-dividend date, with plans to close it right afterwards. Thus, you are stockholder of record when dividend is earned. The two options expire later the same month. If the call goes in the money, your 100 shares are called away, and your capital is freed up. The outcome is that you earn the quarterly dividend with only a few days' holding period. By repeating this strategy every month, you create a risk-free double digit dividend yield.

The opposite can occur as well. If the stock price declines, you escape the position by exercising the long put and selling 100 shares at the put's strike. At the same time, you close out the short call to avoid being left with a naked short position.

Both situations enable you to manage your portfolio by eliminating market risk for virtually no net cost. The collar is an excellent strategy for this purpose, especially in volatile market conditions. The dividend collar allows you to go after exceptionally high yields without risk - and big moves in either direction are welcome, making this one of the few strategies in which unexpected price moves are profitable in either direction.

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