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Managing a Collared Position

Richard Croft
August 1, 2015
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Managing a Collared Position

DEFINITION OF ‘COLLAR’

1. The purchase of an out-of-the money put option is what protects the underlying shares from a large downward move and locks in the profit. The price paid to buy the puts is lowered by amount of premium that is collect by selling the out of the money call. The ultimate goal of this position is that the underlying stock continues to rise until the written strike is reached. (investopedia.com)

I wanted to dedicate this blog to exploring the choices investors have when managing an existing collar position after a stock has moved considerably lower. For this example, we have no better opportunity to debate the alternative choices, than using the Canadian Pacific collar example we published in our March 30th post. Click to read: http://optionmatters.ca/blog/2015/03/30/have-the-rail-stocks-been-derailed/

Back in March I was expressing my concerns about the impact the oil industry would have on the Canadian railway stocks and expressed concerns about the short term risks in the stocks. In particular we focused on the Canadian Pacific Railway which at the time was trading at $229.24. Here is the trade that was opened:

-investor has owned the CP shares for many years and has a considerable capital gain if the shares are sold

– The stock is trading at $229.24 (March 27th, 2015)

– Investor buys the October $230.00 put for $17.50 or $1750.00 debit for every 100 shares

– Investor then proceeds to sell an October $255.00 covered call for $7.50 or $750.00 credit for every 100 shares

– The net cost of the collar is $10.00 or $1000.00 for every 100 shares

Currently as we write this blog, Canadian Pacific Railway is trading at $198.00 (July 9th 2015). The investor has successfully secured the $230.00 sale price out to October. While the investors shares are over $30.00 lower in price, the net value of the options collar is $32.50 (the protective put is worth $33.00 and the covered call is valued at $0.50). With the stock and options combination having almost no time value remaining, the position is virtually delta neutral. Further to that, the protective puts delta is very close to -1, which means that almost all further downside risk that the stock may experience is entirely hedged.

So what should our investor do?

First off, the investor does not have to do anything immediately as the collar position was opened out to the October expiration. But it is worth discussing the choices the investor has if they felt compelled to act.

In the first scenario, the investor feels that the Canadian economy will continue to struggle and that railway stocks are vulnerable to sustained weakness. If the investor simply would like to close the position, they can sell the stock and the options having hedged the drop beyond the cost of the collar.

Alternatively, what if our investor was bullish and felt that this 20% decline in the stock from its highs was just an opportunity. Under that situation, the investor can position themselves to monetize the money made on the put protection to reduce the investors average cost base. When an investor elects to do this, they can always purchase a new, lower strike put as protection. Let’s demonstrate as an example:

– the CP shares are trading at $198.00

– Investor sells to close the October $230.00 put for $33.00

-Investor buys to open the October $190.00 put for $7.00

The investor has extracted a $26.00 net debit from the options which they use to reduce the average cost base (breakeven) of their original position. In addition, the investor now has 100% of the upside of the stock and has a new protection in place to remove all risk below $190.00 a share.

As stated above, the investor can simply do nothing and defer making a decision until October, but dependent on their expectations on the stock, it may be appropriate to take action when and if it is timely to do so.

Richard Croft
Richard Croft http://www.croftgroup.com/

President, CIO & Portfolio Manager

Croft Financial Group

Richard Croft has been in the securities business since 1975. Since February 1993, Mr. Croft has been licensed as an investment counselor/portfolio manager, operating under the corporate name R. N. Croft Financial Group Inc. Richard has written extensively on utilizing individual stocks, mutual funds and exchangetraded funds within a portfolio model. His work includes nine books and thousands of articles and commentaries for Canada’s largest media channels. In 1998, Richard co‐developed three FPX Indexes geared to average Canadian investors for the National Post. In 2004, he extended that concept to include three RealWorld portfolio indexes, which demonstrate the performance of the FPX portfolio indexes adjusted for real-world costs. He also developed two option writing indexes for the Montreal Exchange, and developed the FundLine methodology, which is a graphic interpretation of portfolio diversification. Richard has also developed a Manager Value Added Index for rating the performance of fund managers on a risk adjusted basis relative to a benchmark. And In 1999, he co-developed a portfolio management system for Charles Schwab Canada. As global portfolio manager who focuses on risk-adjusted performance. Richard believes that performance is not just about return, it is about how that return was achieved.

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