The market has been moving higher and implied volatility levels have continued to drop. These are tough times for premium sellers. Adding to the potential frustration is another round of quarterly earnings. Selling a call to help finance a long protective is always a good idea, in my opinion.
Generally, collars are used by investors for this exact situation. But many investors fail to realize what collars can do to protect their equity position at any time, and especially over a potentially volatile earnings announcement. We are getting close to the next onslaught of quarterly earnings. In addition, the economy remains a question mark. Now is as good a time as any to discuss the option collar, a somewhat simple but effective option strategy, once again.
Collar Basics
An option collar is holding shares of stock and buying a put and selling a call on the same underlying. Usually both the call and the put are out of the money when establishing this option combination. One collar represents one long put and one short call along with 100 shares of the underlying stock. One of the main objectives of a collar is to protect the shares of stock from decreasing in value rather than increasing returns.
Tesla Example
Let’s look at Tesla Inc. (TSLA) example from the last earnings season. At the time, TSLA was expected to announce earnings the following week. If an investor were trying to protect his or her stock position from a gap lower after the announcement, he or she could consider a collar. Selling a call option limits the gains if the stock gaps higher rather than lower, similar to how a covered call would limit gains on a stock position. But a collar is done to pay for some if not all of the long put’s premium. As I like to say, there are always trade-offs with options trading.
Look at the chart of TSLA below. In mid-July 2023, the stock had been on quite the run higher, and TSLA was trading at around $279.
A July (July 21st) 800 call could have been sold for around 4.55, which could have been used to purchase a July 265 put for around 5.30.
Calls
Puts
The sold call pays for most of the cost of the long put and the position protects the stock from further losses below the $265 level without much additional cost – 0.75 (5.30 – 4.55) minus commissions. The 265 long put gives the owner the right to sell the stock at $265 up till July expiration. The trade-off is if the stock gaps above $300, the 100 shares will be called away at $300 because they will expire in the money (ITM) and be automatically assigned if the short call is not bought back before expiration. If assigned, the long 100 shares will be sold at $800 regardless of how high they are trading at expiration.
Sell the Put
Here is the part most investors don’t think about when using options. Just because you have the right to sell shares by buying a put does not mean you have to. If an investor has no intention of selling the shares even if the stock gaps lower, he or she can sell the put and possibly collect a profit as well.
Final Words
Collars don’t always make sense. But when an earnings report could lead to a sizable gap lower, an investor should consider the alternatives, which could be much worse. Let’s hope all your stocks will gap higher after earnings!
