WRITING AGAINST A COLLAR

December 31st, 2011

Suddenly several option writers I know have come up with a similar idea. The idea is to buy a leap collar, and sell monthly (or weekly) options against the collar. Here is how that works:

A “leap” is an option that is at least one year out in expiration. As I write this in January 2012, the leaps expire in January 2013 or later. Sometime the leaps continue to be called leaps as time goes on and the expiration date becomes less than a year, but that is not a practice I recommend.

A collar is a two-option position that protects against a stock movement in either direction. For example, a perfect collar would be to buy both a put and a call with the strike price at the existing market price. So if the subject stock is at $100, you buy a 100 put and buy a 100 call. If the market moves in either direction you make money on one of the puts, but lose your premium on the other. Whether or not you end up with a profit or a loss depends on the amount of movement on the stock during the option period: if it moves more points than the cost of the collar, there is a profit, otherwise there is a loss.

To have a perfect collar is usually expensive. To buy two at the money options a year out requires quite an outlay of cash. So a different collar is sometimes selected, and this is usually the difference in the strategies.

One simple change is to buy options that are out of the money. These cost a lot less. So if the stock is at $100, you might buy a $110 call and buy a $90 put. This protects you from a large movement in the stock price, but there is a window between 90 and 110 where you can lose money on the sales described below. The goal here is to make more on selling short-term options against the collar than the cost of the long-term options (see below).

A variation on this, to reduce the cost even further, is to buy a spread on each side of the current stock price. A spread is a two-option strategy where part of the cost of the purchase is offset by a sale of an option at the same expiration but with a strike price further away from the stock price. For example, in the collar position above, in addition to buying the put at $100, you sell another put at $90, creating a put spread. The same is done to create a call spread buy selling another call at $110. The problem with this strategy is that if the stock moves substantially an adjustment in one of the spreads must immediately be made to avoid a loss on the long position, which was supposed to just be a hedge.

A more complex strategy is to SELL in the money positions, or one of them, to create the collar. By selling one option and buying the other the net premium is greatly reduced, but there is always a window of loss that might require an “adjustment” during the life of the collar. The adjustment CAN take place as part of the short terms sales described below.

An example here would be to BUY the 90 call, (in the money) to protect against an increase in the stock price, and to SELL the 90 put (in the money) to protect against a decline in price below $100 up to the amount of the premium.

As the stock price goes up, the 90 call, for which you paid $10 intrinsic value plus premium value, increases in value because if I can buy the stock at $90 I make $1 for every dollar in price the stock goes up. So when I sell a short put against the collar later, if the stock price increases I might lose money on the new short put, but make it up on the long call (up to a $10 increase in the stock price).

As the stock price declines, my long call position loses value. But I plan to lose everything I paid for the 90 call. The trick is for the multiple premiums I collect from monthly sales to be greater than the cost of the call (less the premium received on the on the long put).

By selling the 90 put I can be “put” the stock at $90 a share. No one will make me buy the stock at $90 if they can buy it on the market for $90 or less. So if the underlying stock price stays at $90 or above, I get to keep the whole premium I collected when I sold the put. That means that if the underlying stock does not decline 10% during the month while I sell a short term, 30 day put, I have some premium on hand to act as a hedge against a loss on the short-term sale. To be completely safe, however, one should still hedge the short-term put sale with a very cheap long put to create a put spread.

There are a lot of varieties that these long collar positions can take.

Having hedged against a major change in the stock price, the option writer then sells options against the collar each month, hopefully 12 times for a one year position, during the life of the collar. Statistically what this usually predicts is that it takes between 3-4 months (or sales) to recoup the cost of the collar, and then the remaining sales create a very large profit, on a percentage basis.

Both a put and a call can be sold each month to generate premiums, and the collar hedges the short positions. If the stock makes a big move during the month, it can create a big loss in the short position, with a corresponding gain on one side of the collar, and the collar—or part of it– has to be closed out and moved to a different strike price to cover the loss on the short position.

This is a very interesting, lost cost, high yield strategy. The main flaw is that it takes a lot of watching, both from the point of view of monthly or weekly writing, plus adjusting to large price changes.

Overall losses obviously can arise in the case of wildly fluxuating stock prices, so you have to stay on top of the market on a regular basis. And if you sell puts on both the long term and the short term and are put the stock, I hope it’s a stock that you love and want to own.
merv

Market Update For Week Ending 12/23/2011

December 26th, 2011


Index Close Net Change % Change YTD YTD %
DJIA 12,294.00         +427.61         3.60         +716.49         6.19        
NASDAQ 2,618.64         +63.31         2.48         -34.23         -1.29        
S&P500 1,265.33         +45.67         3.74         +7.69         0.61        
Russell 2000 747.39         +25.34         3.51         -36.26         -4.63        
International 1,401.60         +30.82         2.25         -256.70         -15.48        
10-year bond 2.03%        +0.18%          -1.26%          
30-year T-bond 3.06%        +0.20%          -1.27%          
International index is MSCI EAFE index. Bond data reflect net change in yield, not price. Indices are unmanaged and you cannot directly invest in an index.
More market data

Market Wrap
Stocks around the world rebounded after the latest efforts from the European Central Bank revived confidence in the continent’s banking system and the euro zone. The Dow industrials surged 3.60%, while the broad S&P 500 gained 3.74%, leaping back into positive territory for the year to date. The Russell 2000 bounced 3.51%, but disappointing news for a few bellwethers in the technology-rich Nasdaq left that index up only 2.48%. Foreign shares climbed 2.25% in dollar terms, while bond yields reflated as Treasury prices sank. For more on recent trading activity, please read:
http://www.cnbc.com/id/45776170

What The Tax Cut Extension Means For The Economy And America
After protracted debate, Congress finally agreed to a short-term extension of a $33 million package of tax breaks and stimulus measures. While many lawmakers would like to see various programs extended for the entirety of 2012, the last-minute negotiations made more than a two-month time frame difficult to achieve. Unfortunately, this means that some tax cuts are now set to expire at the end of this year. For more, please read:
http://money.cnn.com

European Central Bank Pumps $600 Billion Into Troubled Banks
Policy makers in Europe stepped up to offer cash-strapped financial institutions as much cash as they wanted this week, payable in the form of three-year loans. Banks eagerly accepted, borrowing a record $600 billion to replenish their cash positions. While the move helped stabilize the euro and investor confidence alike, some wondered how long the good feelings would last. For more, please read:
http://www.reuters.com

results of a complex trade from an avid option writer in California

December 24th, 2011

Anthony Hills
Hills Motors/Hills Industries
4011 Pacific Blvd
San Mateo,CA 94403.
650 573 7425
Fax 650 573 8721

— Grand total profit on this trade was $50 since the VIX drop killed long premiums as I suspected could happen. Closed it due to low weekly premiums available to sell and time for the holidays.Tony
10 SPY 12/23/2011 124.00 C-10$0.89
70 SPY 01/21/2012 131.00 C70$0.39
10 SPY 01/21/2012 115.00 P10$0.89

SPY 12/23/2011 124.00 C
-10
$2.15
($2,150.00)
$760.00
($914.97)
($1,235.03)
— Trade
SPY 01/21/2012 131.00 C
70
$0.65
$4,550.00
$700.00
$9,338.37
$1,800.00 — Trade

SPY 01/21/2012 115.00 P
10
$0.40
$400.00
$90.00
$915.03
($515.03)
Trade
————
+$50- profit

NUAN

December 23rd, 2011

Several friends have mentioned the great potential of voice recognition programs. The leader in that field seems to be NUAN. I read that they have
a contract with IBM to work together on at least one project.

With NUAN at around $24 I sold the April 21 puts and took in $1,100. I am perfectly happy to buy 1000 shares at an effective price of $20. And if
the stock does not dip below 21 and I just keep the $1,100 that’s OK too.

merv

December 18th, 2011

As they say, there’s good news and bad news. Most stock market web sites tout their terrific earnings and stock picks. This weekend I looked at my portfolio and focused on Walgreens. I bought WAL at a number of different prices over the years. I took a nice profit on two of the trades when I bought low and sold high. But I am still sitting with 1000 shares I bought at 45, and the stock has dropped to 34. I’ve been writing calls against it, and picked up about $1,000 twice, and am sitting with the January 39’s now on which I will probably pick up another $1,200. So my return on the investment is not bad, but I’ve got a long way to go before I recoup an $11,000 drop in value. I’m down about $8,000 so it will probably take me another two years of writing calls against the stock to break even—unless the stock moves up. And meanwhile my cash is tied up.

That’s the bad news. But there is good news.

Walgreens seems to be a terrific company. Between 2010 and 2011 sales went up 7%. Earnings were up 38%! New locations are continually opening. The ratio of prescription drubs to non-prescription drugs is holding steady. The stock looks to me like a really good buy, so I’m going to hold it can keep writing calls against it.

What is the moral of this story? First of all, everyone occasionally buys at the high. The difference is that if you are an option writer, by writing covered calls you can afford to hold on to stocks that drop sharply, because of the premium income, if you still believe in the company. Even if your cash is tied up so long as you are receiving a good cash return on it it’s good news.

Market Update For Week Ending 12/16/2011

December 18th, 2011
Index Close Net Change % Change YTD YTD %
DJIA 11,866.39         -317.87         -2.61         +288.88         2.50        
NASDAQ 2,555.33         -91.52         -3.46         -97.54         -3.68        
S&P500 1,219.66         -35.53         -2.83         -37.98         -3.02        
Russell 2000 722.05         -23.35         -3.13         -61.60         -7.86        
International 1,370.78         -57.41         -4.02         -287.52         -17.34        
10-year bond 1.85%        -0.20%          -1.44%          
30-year T-bond 2.86%        -0.24%          -1.47%          
International index is MSCI EAFE index. Bond data reflect net change in yield, not price. Indices are unmanaged and you cannot directly invest in an index.
More market data

Market Wrap
Another volatile week left global stock markets in retreat as investors grappled with the reality that a concrete solution to the euro’s plight seems as far away as ever. The Dow industrials held up best, down 2.61%, while the broad S&P 500 shed 2.83% and the technology-rich Nasdaq sank 3.46%. Small-cap and foreign shares, seen as especially sensitive to economic risk, suffered as well, down 3.13% and 4.02%, respectively. As money moved out of stocks and into the relative haven of Treasury debt, bond yields compressed even further. For more on recent trading activity, please read:
http://www.cnbc.com/id/45696527

Washington Gears Up For The Next Budget Debate
At Friday’s market close, members of Congress were still arguing over the extent of federal spending in the new year. While most political analysts suspected that a last-minute deal would probably keep the government from shutting down in the near term, some worried that the next round of debate would be even more contentious. With an election year looming, the stakes have rarely been higher. For more, please read:
http://www.bloomberg.com

Federal Reserve Holds The Line Between Rate Policy And Stimulus
The Federal Reserve’s last monetary policy meeting of 2011 brought little in the way of new insight into what Ben Bernanke and company are thinking about the economy. However, it did upset some investors who were hoping for a third round of quantitative easing to stimulate the economy and the markets. On the one hand, the absence of a big “QE3″ program indicates that the Fed thinks the economy is healthy enough to not need additional support. But for those looking for a massive pre-holiday gift from central bankers, the disappointment was significant. For more, please read:
http://money.cnn.com
_E_River

a complex combination

December 13th, 2011

Further to my last email about what friends are doing, my friend Tony is doing the following type of trade:

He bought 20 calls S&P 500 Dec 131 @ $.85
He sold 10 puts on the same index, Dec 124’s @ $2.28
So he took in $2,280 and paid out $1,700 for a net credit of $580
Then he sold 1000 shares of SPY short.

This is really the equivalent of two separate combinations, but if you work it out he makes a really nice profit if the SPY moves up (he had about two weeks of time).
The only risk is if the index moves well below 124 during the two week period. That would be more than a 7% move, which doesn’t happen very often in that short a time period, so this looks like a pretty good strategy.

Does anyone see a problem with it?

merv

Market Update For Week Ending 12/9/2011

December 12th, 2011


Index Close Net Change % Change YTD YTD %
DJIA 12,184.26         +164.84         1.37         +606.75         5.24        
NASDAQ 2,646.85         +19.92         0.76         -6.02         -0.23        
S&P500 1,255.19         +10.91         0.88         -2.45         -0.19        
Russell 2000 745.40         +10.38         1.41         -38.25         -4.88        
International 1,428.19         -12.88         -0.89         -230.11         -13.88        
10-year bond 2.05%        +0.01%          -1.24%          
30-year T-bond 3.10%        +0.06%          -1.23%          
International index is MSCI EAFE index. Bond data reflect net change in yield, not price. Indices are unmanaged and you cannot directly invest in an index.
More market data

Market Wrap
Tension in Europe kept global stock markets on the defensive for much of the week, although U.S. equity benchmarks managed to close with significant gains. The blue-chip Dow industrials and small-cap Russell 2000 fared best, up 1.37% and 1.41%, respectively, while the broad S&P 500 gained 0.88%. The technology-rich Nasdaq ended the week up 0.76%. Foreign shares sank 0.89% in dollar terms as an eleventh-hour deal to save the euro came too late for overseas traders to digest. Bond yields edged higher. For more on recent trading activity, please read:
http://bottomline.msnbc.msn.com

Jobless Claims Fall To 9-Month Low As More Find Work
The number of Americans filing for unemployment benefits dropped below 400,000 last week for the first time since February, giving economists and investors alike hope that the U.S. economy is recovering. Although some worried about seasonal factors distorting the data, even vague strength in the job market was an encouraging sign. For more on the latest on the economy, please read:
http://money.cnn.com

New European Treaty Gives Euro A New Lease On Life
A no-nonsense proposal on tighter debt and economic standards for members of the euro zone brought the approval of most European countries and muted applause from investors. Under the new rules, most European nations agree to keep their budgets under control. In return, the strongest economies in the union — France and Germany — will assist the International Monetary Fund and other agencies as they work to bail out weaker members. The news was more or less what markets were looking for from Brussels, but only time will tell whether the euro’s problems are truly solved. For more, please read:
http://www.cnbc.com/id/45612513

December 10th, 2011

TAKING ADVANTAGE OF TIME

More and more people that email me about their option trading techniques seem to be taking advantage of the difference of premium decay on long term positions and short term positions.

There are a number of complex strategies employed. But perhaps the most simple to understand is when you buy a long term straddle, perhaps 12 months out or further, and sell 30 day options against it each month. If you can stay on top of it and do it twelve times during the 12-month period and collect in 12 premiums, the total of the premiums is almost always greater than the initial cost of the straddle.

The straddle is designed so that if the stock goes up, one side loses money while the other side makes approximately the same amount, and vice-versa.

This is really must a variation on covered call writing, where the call sale is only 30 days out from expiration. But instead of putting up the money to own the underlying stock, and taking the risk of a decline in that underlying value, the long position against which the shorts are written are options.

One advantage of doing it with options is that you can afford to do it on high volatile stocks, with bigger premiums, that you would not want to own.

I am collecting strategies using this philosophy. If you have one I would love to hear from you.

merv

Market Update For Week Ending 12/2/2011

December 5th, 2011
Index Close Net Change % Change YTD YTD %
DJIA 12,019.42         +787.48         7.01         +441.91         3.82        
NASDAQ 2,626.93         +185.42         7.59         -25.94         -0.98        
S&P500 1,244.28         +85.61         7.39         -13.36         -1.06        
Russell 2000 735.02         +68.86         10.34         -48.63         -6.21        
International 1,441.07         +119.84         9.07         -217.23         -13.10        
10-year bond 2.04%        +0.07%          -1.25%          
30-year T-bond 3.04%        +0.12%          -1.29%          
International index is MSCI EAFE index. Bond data reflect net change in yield, not price. Indices are unmanaged and you cannot directly invest in an index.
More market data

Market Wrap
Markets soared after global banks intervened to shield weakened European institutions from the prospect of a second credit crunch. In the euphoria, the Dow industrials and Nasdaq leapt 7.01% and 7.59%, respectively, while the S&P 500 gained 7.39%. The Russell 2000 rebounded a full 10.34% and the foreign MSCI EAFE index jumped 9.07%. Bond yields edged higher as money poured back out of the Treasury market into stocks. For more on recent trading activity, please read:
http://bit.ly/rzNT5F

Unemployment Plunges As U.S. Businesses Start Hiring Again
Friday’s monthly job market report brought investors plenty of hope that the U.S. economy is still recovering from the 2008-9 recession. The unemployment rate sank to 8.6% in November, its lowest level in 2-1/2 years, as U.S. managers hired a net 120,000 people during the month. Given the gloom around the job market, the news provided fresh confidence, if not outright cheer. For more, please read:
http://money.cnn.com

Central Bank Move Lifts Stocks, Commodities, Spirits
The Federal Reserve and other central banks teamed up on Wednesday to ensure that financial institutions had all the cash they need to survive a protracted euro crisis. The intervention fed some grousing about why it was required, but on the whole investors reacted to the move as a comforting gesture that officials are ready to protect the markets. Global stocks and commodity prices alike surged in response. For more, please read:
http://www.businessweek.com
-central-bank-liquidity.html