Learn about the investment strategy that uses options to preserve or “lock in” profit on your stock while allowing you to benefit from additional upside gains.
- The use of collars can be an effective tool to preserve a range of value and manage risk on your stock holdings.
- It can also be an alternative to selling the stock and currently recognizing taxable gains.
- Costless collars should be used only after a careful analysis of your tax situation, liquidity and risk management needs, the diversity of your assets, and the nature of the stock in question.
Do you own a stock that has increased significantly in value since you bought it? Maybe you’ve thought about using this money to buy that new boat next year when you retire or taking some of that gain to help finance the purchase of a vacation home. Should you sell the stock now and be satisfied with the current profit? Perhaps you don’t want to sell it yet because you believe it still has a little more upside potential, but you may also be concerned, given the volatility of the market, that you may lose the gains you so patiently earned. Furthermore, from a tax-planning standpoint, this year may not be the best time to get out because of a large bonus you are expecting.
The costless collar strategy
Is there some way of having your cake and eating it too? There is a strategy using options that can preserve or “lock in” profit on your stock while allowing you to benefit from additional upside gains. In effect, you can place a “collar” around your stock which limits downside risk while taking advantage of upside movement. And you can do it at effectively little or no cost through a process called a “costless collar.”
Step one: Protect or lock in your profit
There are two parts to creating a costless collar. The first step is to protect or lock in your profit. This is done by purchasing a put contract on the stock you own. A put contract gives you the right to sell the underlying shares of stock, during the term of that contract (typically up to twelve months), at the price specified in that contract (the “strike price”)— regardless of the then-prevailing market price for those shares. In effect, the put’s strike price establishes a minimum sale price (or “floor”) for your stock regardless of the stock’s market price behavior during the term of your put. For example, if you own 1,000 shares of a stock currently trading at $110 per share that cost you $25 per share, you have an (unrealized) gain of $85,000. Put contracts to sell those shares at $100 per share for twelve months would ensure, or lock in for you, a $75,000 gross profit, no matter how much the shares dropped in value during that time. Note that this insurance does come with a cost. A put contract with a strike price of $100 for a term of twelve months may cost $11 per share (hence, $11,000 for puts on 1,000 shares). However, this cost may be offset by the benefits received from creating the second part of the collar, as described below.
Step two: Selling a call option on your stock
To finance the “insurance” provided by the put contract, you could sell a call option on your stock. Selling a call contract gives the buyer the right to purchase (or “call”) your underlying shares, during the term of that contract, at the price specified in that contract (the call’s strike price). Let’s assume that a call contract for your shares with a strike price of $140 for a term of twelve months currently sells for $12 per share; therefore, a call option contract on these terms for 1,000 shares would sell for a total of $12,000. In this case, the proceeds that you would receive from selling these calls ($12,000) would exceed your cost of purchasing the above puts ($11,000); hence, there would be no net cost to you for creating this protective collar. If the stock price later rises to $140 or higher, and the holder of the call option calls your stock, you would be obligated to sell it for $140 per share. However, you would still benefit, as that sale would yield $30,000 of additional profit over your current unrealized gain (i.e., a gross profit of $115,000— that is, $140,000 minus $25,000—which is $30,000 more than your current $85,000 of unrealized gain), and you did so with downside protection at no net cost to you. The costless collar is an effective strategy for protecting the value of your investment.
Other benefits of a collar
You may have another challenge. Your stock holdings may represent a large portion of your net worth, but perhaps you don’t want to sell them at this time, or you can’t because they consist of restricted stock. If you need cash for other purposes or realize that your portfolio should be more diversified, what can you do without selling your stock holdings? One possibility is to take the stock to your banker and use it as collateral for a loan. In that case, it is conceivable that you could borrow up to a portion (perhaps 5% to 70%) of the stock’s market value.
The downside of a protective collar strategy
If the stock skyrockets in value during the life of the call contract, you will miss any additional profit above the call’s strike price if the holder of the call option calls your stock. As with any investment strategy, costless collars should be used only after a careful analysis of your tax situation, the diversity of your assets, your particular liquidity and risk management needs, and the nature of the stock in question. In the appropriate situation, it can be an effective tool to preserve a range of value and manage risk on your stock holdings and can be an alternative to selling the stock and currently recognizing taxable gains.
This article is for informational purposes only and is not intended as an offer or solicitation for the sale of any financial product or service or as a determination that any investment strategy is suitable for a specific investor. Investors should seek financial advice regarding the suitability of any investment strategy based on their objectives, financial situations, and particular needs. This article is not designed or intended to provide financial, tax, legal, accounting, investment, or other professional advice since such advice always requires consideration of individual circumstances. If professional advice is needed, the services of a professional advisor should be sought. All investments involve risks, including possible loss of principal. There is no assurance that any investment strategy will be successful. Diversification does not ensure a profit or guarantee against a loss.