Low-Cost Insurance Against a Drop in Share Price

As the following chart shows, the price of shares in Waste Connections Inc. (WCN), which is trading at $123.70 as these lines are being written on July 25, 2019, has delivered an excellent return of 28.6% since bottoming out at $96.16 on December 24, 2018. The chart shows that the stochastic oscillator (Stoch), an indicator of momentum, has begun to falter for the first time since then, falling to below 80. The fact that WCN is now trading below its 13 and 34-day moving averages is also not a good sign. An investor who is still holding onto the shares may be tempted to sell them if there are any additional signs of weakness.

Chart 1: Changes in the Price of WCN as at July 25, 2019 ($123.70)

Source: Tradingview.com

Put options allow you to set a future sale price on the shares underlying the contract. If the share price falls below the option’s strike, the holder of the put options can then sell the shares at the strike price. The advantage of put options is that you can take advantage of a price increase, while still being protected against a drop. However, this advantage comes at a price, since you need to pay a premium to acquire this right to sell. But there is a way to reduce this cost; it involves writing a call option on the stock, and using the premium received to pay for all or part of the put options. But in doing so, we are obliged to forego any potential profit if the shares rise above the strike price of the call options written. This strategy is widely known as a collar.

Collar Strategy

An investor interested in implementing this strategy could write call options expiring on October 18, 2019 with a strike price of $125 at a price of $2.70 per share, and then use these funds to buy put options with the same expiration and a strike price of $120, at a price of $2.00 per share. The investor would therefore receive a net premium of $0.70 per share. The following table shows the cash flows for a position of 1,000 WCN shares.

Table 1: Collar Strategy on WCN

As can be seen in Table 1, once the collar strategy has been implemented, the cost of 1,000 shares of WCN on July 25, 2019 is $123,000 ($123,700 – $2,700 + $2,000).

Chart 2: Profit and Loss Diagram for the Collar Strategy on WCN

Chart 2, above, illustrates the profit and loss diagram for the collar strategy on the 1,000 shares held by the investor. As mentioned above, we can see that at a share price of $125 or more, the position’s profitability is limited to $2,000. This is the $125 strike price at which the 1,000 shares will be sold, for a total of $125,000, less the $123,000 cost of the shares. On the downside, we can see that the investor’s losses are limited to $3,000. This is the $120 strike price at which the 1,000 shares will be sold following the exercise of the put options, for a total of $120,000, less the $123,000 cost of shares. In sum, by implementing this collar strategy the investor ensures that he can sell his shares for a minimum of $120,000 in the event that the share price falls, or for $125,000 if the share price returns to a bullish trend.

Conclusion

The collar strategy protects against a drop in the price of one’s shares by writing call options to finance all or part of the purchase of put options. However, since nothing comes for free in finance, the reduced cost of protection also limits profitability in the event that the share price rises. It is therefore important to understand this situation before you implement the strategy.

Good luck with your trading, and have a good week!

The strategies presented in this blog are for information and training purposes only, and should not be interpreted as recommendations to buy or sell any security. As always, you should ensure that you are comfortable with the proposed scenarios and ready to assume all the risks before implementing an option strategy.

The 12^th annual Options Education Day in collaboration with the Options Industry Council (OIC) will take place in Toronto on September 14, 2019 at the Westin Harbour Castle. Seats are limited, so sign up before August 19 for the early bird pricing! To learn more: m-x.ca/oed