March 55 call at $1.50 and buying a January 50 callat $6.50.
Market Opportunity: Anticipate a short-term move higher in a trendingstock. Look for time volatility skew to increase odds of success.
Maximum Risk: Limited to the net debit. In this case, the risk is losingthe premium paid for the long call ($650) minus the premium received forthe short put ($150) for a maximum risk of $500.
Maximum Proﬁt: During the life of the short option, the proﬁt is limiteddue to the possibility of assignment. In this case, above $55 a share, thestrategist will be forced to engage in follow-up action.
Upside Breakeven: No set formula. Will vary based on IV assumptions.
Downside Breakeven: No set formula. Will vary based on IV assumptions.
Margin: Amount subject to broker’s discretion.
COLLAR SPREAD
Collar spreads are usually one of the ﬁrst combination option trades a per-son is exposed to after getting a grasp of what basic puts and calls are allabout.  They  are  usually  presented  as  appreciating  collars  or  protectivecollars. However, not much mention is given to the inherent ﬂexibility ofthis position and how, as a trader, if you want to put just a little bit moreeffort into the trade, you can increase your returns.
There are two types of collar trades: the protective collar and the ap-preciating  collar.  The  protective  collar  is  chosen  when  a  person  alreadyowns the stock and has a bearish outlook but still wants to hold the stock.In  this  case,  the  trader  would  purchase  an  at-the-money  put  and  at  thesame  time  sell  an  at-the-money  call  to  ﬁnance  that  put.  This  essentiallylocks  in  the  current  price  and  protects  the  trade  from  losses  until  suchtime when the bearish scenario changes.
The  other  type  of  collar  is  an  appreciating  collar.  This  is  the  onewhere you can make money and indeed trade dynamically if you desire.The appreciating collar involves buying stock and for every 100 shares ofstock  purchased  buying  an  at-the-money  put  and  selling  an  out-of-the-money call to ﬁnance the put. The key to this strategy is selecting a stockthat has been in the news, whose volatility is high, and for which a typeskew exists (a type skew is when a volatility skew exists between the put
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purchased and the call sold). By doing so you will ﬁnd that your risk willbe reduced to virtually nothing.
Now what if the stock you have chosen gets on a nice steady run andis  at  or  goes  above  your  appreciating  collar  strike  price?  If  it  is  at  thestrike  price,  you  can  continue  to  hold  and  eventually  let  the  calls  andputs expire worthless, and then sell the stock to take your proﬁts. If it isabove the strike price, the calls you sold will carry away the stock andthe  put  expires  worthless;  you  garner  the  maximum  proﬁt  potential  ofthis position.
To establish a collar, many strategists buy (or already own) the actualshares,  buy  an  at-the-money  LEAPS  put,  and  sell  an  out-of-the-moneyLEAPS call. Doing so combines the covered call with a protective put. Intheory, the call and put that are equidistant from the share price shouldcarry the same premium. So, if you own a stock at $50 a share and want toprotect the downside risk, you could buy a put. However, the put will costmoney and the premium would be deducted from your account. Anotheroption is to buy a 45 put and sell a 55 call. The sale of the call will reducethe cost of the purchase of the put.
Collar Mechanics
Let’s  consider  an  example  of  a  collar  using  XYZ.  During  the  month  ofFebruary, XYZ is trading for $50 a share and an investor has been hold-ing the shares for some time. She doesn’t expect much movement in thestock, but believes that there is a 10 percent chance that the price willdecline during the next four months and wants to hedge her exposureto all stocks—including XYZ. Therefore, with the stock trading for $50,she buys an August 45 put with six months left until expiration and sellsan  August  55  call.  The  options  are  both  ﬁve  points  out-of-the-money(OTM).
Since both the put and the call are ﬁve points OTM, they have similarpremiums.  In  this  case,  each  option  trades  for  roughly  $3.  Luckily,  withthe stock trading for $50, the strategist is able to buy the put and sell thecall at the same price. The cost of the trade is therefore zero because theshares are already held in the portfolio and the cost of the put is offset bythe sale of the call. The risk to this trade is to the downside, but is limitedto  the  strike  price  of  the  put.  The  maximum  risk  is  equal  to  the  initialstock price minus the strike price of the put plus the net debit (or minusthe net credit). In this case, the maximum risk equals $500: [(50 – 45) + (3– 3)] × 100 = $500. The maximum risk occurs if the stock price falls to orbelow the lower strike price (i.e., $45). Therefore, this strategy offers thetrader a limited risk approach that makes money in either direction. Therisk graph of this trade is shown in Figure 10.9.
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FIGURE 10.9 Collar Spread Risk Graph
While  there  is  limited  risk  associated  with  the  collar,  there  is  alsolimited reward. If the stock price moves higher, the position begins tomake  money.  However,  the  maximum  reward  is  capped  by  the  strikeprice of the call. If the stock price moves above the strike price of thecall, the chances of assignment will increase. In other words, there is agreater probability that the stock will be called away at $55 a share. Atthat  point,  the  maximum  proﬁt  is  realized.  Namely,  the  higher  strikeprice  minus  the  stock  price  minus  the  debit  (or  plus  the  credit)  is  themaximum  gain  associated  with  the  collar.  In  this  case,  it  equals  $500:(55 – 50 + 0) × 100 = $500. The maximum proﬁt levels off at $55 a share,which  is  the  point  that  assignment  becomes  likely.  The  breakeven  isequal to the stock price plus the net debit (or minus the net credit). Inthis case, it is simply the price of the stock at the time the collar was es-tablished, or $50 a share.
What are the risks associated with buying a put and selling a call onshares  that  we  already  own?  First,  the  stock could  move  above  $55,  re-quiring us to sell it at a price lower than the current value; and second, thestock could  still  trade  as  low  as  $45  without  seeing  any  proﬁt  from  theput. However, this is also the case if we just held the stock as well. Muchlike catastrophe insurance, the idea behind a collar is that we don’t wantto be stuck holding a stock as it falls into a tailspin. The collar is a form ofdisaster insurance.
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Exiting the Position
While a collar can be tailored to make money when shares move higher, itis normally used for protection. It does not require a lot of attention. Ifthe shares shoot higher, the stock will probably be called (due to assign-ment) when the time premium has fallen to a quarter of a point or less.Therefore, if the price of the stock has risen above the strike price of theshort call and the strategist does not want to lose the shares, it is betterto close the short call by buying it back. If not, the call will be assignedand  the  trader  will  make  the  proﬁt  equal  to  the  difference  between  theexercise  price  and  the  original  purchase  price  of  the  stock  minus  anydebits (or plus any credits). The put, on the other hand, will protect thestock if it falls. If the stock drops sharply, the strategist will want to buyback the long call and then exercise the put. If the short call is not closedand  the  put  is  exercised,  the  strategist  will  be  naked  a  short  call.  Al-though it will be deep OTM, it will still expose the trader to risk. There-fore, it is better to buy back the short call and close the entire position. Ifthe stock stay in between the two strike prices, the trader can roll the po-sition  out  using  longer-term  options  or  do  nothing  and  let  both  optionsexpire worthless.
In  addition,  if  you  can  monitor  your  collar  trade  a  bit  more  closely,you can signiﬁcantly enhance your returns when the stock in your appre-ciating collar rallies to your strike price. How can you do this? By rebrack-eting your collar. To rebracket the trader ﬁrst would sell the put and buyback the call, then would recollar or create a new collar by buying a newat-the-money put and selling a new out-of-the-money call to create a newappreciating collar at the higher strike price. This is far better than just sit-ting  and  waiting  for  everything  to  expire  after  you  already  have  cappedyour proﬁts.
Let’s look at a quick example for stock XYZ. We buy 100 shares of thestock at $50. We then buy the 50 put and sell the 55 call with a year still togo before expiration. Just a few months into the trade, the stock is tradingat the $55 level. Now to lock in proﬁts and pursue further appreciation inthe  stock,  we  would  sell  the  50  put  and  buy  back  the  55  call.  We  thenwould create another appreciating collar by buying the 55 put and sellingthe 60 call—locking in proﬁts as well as being able to participate in fur-ther gains. This can be done over and over again throughout the year asthe stock continues to climb. This technique gets around the capped prof-its limitation the standard appreciating collar possesses.
If  you  have  the  time,  the  dynamic  trading  of  collars  might  be  some-thing of interest. However, the traditional collar is still an excellent low- orno-risk strategy, which, if placed correctly, offers an excellent return. Infact, the return is enhanced even more if done in a margin account.
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Strategy: Buy (or already own) 100 shares of stock, buy an OTM put, andsell an OTM call. Try to offset the cost of the put with the premium fromthe short call.
Market  Opportunity: Protect  a  stock  holding  from  a  sharp  drop  for  aspeciﬁc  period  of  time  and  still  participate  in  a  modest  increase  in  thestock price.
Maximum Risk: [Initial stock price – put strike price + net debit (or – netcredit)] × 100.
Maximum Proﬁt: [(Call strike price – initial stock price) – net debit (or +net credit)] × 100.
Breakeven: Initial stock price + [(put premium – call premium) ÷ numberof shares (100)].
Collar Case Study
As we have seen, collars are combination stock and option strategies thathave limited risk and limited reward. With this strategy, the strategist buys(or  owns)  the  shares,  sells  out-of-the-money  calls,  and  buys  out-of-the-money puts. It is a covered call and a protective put (which involves thepurchase of shares and the purchase of puts) wrapped into one. The ideais to have the downside protection similar to the put, but to offset the costof that put with the sale of a call. As with the covered call, however, thesale of a call will limit the reward associated with owning the stock. If thestock price moves higher, the short call will probably be assigned and thestrategist  must  sell  the  shares  at  the  short  strike  price.  This  strategy  isgenerally implemented when the trader is moderately bullish or neutral ona stock, but wants protection in case of a bearish move to the downside.
Let’s  consider  a  collar  example  using  shares  of  American  Interna-tional  Group  (AIG),  which  are  trading  for  $50.18  during  the  month  ofFebruary 2003. In this example, the strategist buys 100 shares, buys anAugust 45 put for $3.30, and sells the August 55 call for $3. The sale ofthe  call  nearly  offsets  the  purchase  of  the  put  and  the  debit  is  only$0.30,  or  $30  a  contract.  One  hundred  shares  of  stock  cost  $5,018  andthe total trade results in a debit equal to the cost of the shares plus thenet  debit  or  $5,048:  ($30  +  $5,018).  The  maximum  risk  is  limited  alsodue to the protective put. No matter what, until the options expire, thestock  can  be  sold  for  the  strike  price  of  the  put,  or  $4,500  per  100shares. The upside proﬁt is also limited. If the stock price moves above$55, the call will probably be exercised. In that case, the stock is sold for
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$5,500 per 100 shares and the trader makes a proﬁt. The breakevens areequal to the total cost of the trade per share. In this case, the breakevenoccurs at 50.48.
The  risk  curve  in  Figure  10.10  shows  the  proﬁt/loss  possibilities  forthe  collar.  Notice  that  the  trade  generates  proﬁts  if  the  stock  moveshigher,  but  the  gains  are  limited  by  the  strike  price  of  the  call.  At  $55  ashare,  proﬁts  level  off.  In  between  the  breakeven  and  the  upper  strikeprice,  the  trade  is  proﬁtable.  On  the  other  hand,  if  the  stock  falls  below$50.48, the trade begins to lose money. The losses are capped by the lowerstrike price of the put, or $45 a share. Therefore, the collar carries someupside rewards, but also limited risks. For that reason, many traders viewthe strategy as a form of low-cost disaster insurance.
So, what happened to our AIG August 45 put/55 call collar? Well, threemonths later, in mid-May 2003, shares of AIG rose to $56 a share. At thatpoint, the maximum gain had been recorded and, if the call had not beenassigned  (which  it  probably  would  not  have  due  to  the  remaining  timevalue), the position could be closed at a proﬁt. The August 45 put is sold ata loss for the bid price of 60 cents a share. The August 55 call is boughtback (buy to close) for the offering price of $3 and AIG is closed for $56.As a result, the call is a wash. The put results in a $270 loss and the stockis  sold  at  $5.82  a  share  for  a  $582  proﬁt.  The  total  proﬁt  on  the  trade  is$312: ($582 – $270). Excluding commissions, this collar generated a three-month 6.2 percent proﬁt.
Today: 177 days left 118 days left 59 days leftExpiration
Close= 
50.18
51.00 
51.00 
 49.65 
 50.18 
  –0.74
06
05
ecirPkcotS
tiforP
008
006
004
002
0
002–
004–
006–
008–
11/15 
12/09 
12/31 
01/23
40 
 50 
  60
Currently:    02–19–03
FIGURE 10.10 AIG Collar Spread (Source: Optionetics Platinum © 2004)
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Collar Case Study
Strategy: With AIG stock trading at $50.18 a share in February 2003, buyone  August  AIG  45  put  at  $3.30,  sell  one  August  AIG  55  call  at  $3,  andbuy 100 shares of AIG stock. Total cost of trade is $5,048.
Market Opportunity: The stock is expected to make a modestly bullishmove higher before expiration.Maximum Risk: Limited to initial stock price – (put strike price × 100) +net debit. In this case, $548: [5,018 – (45 × 100)] + 30.
Maximum Proﬁt: Limited as the stock price moves higher as the short callmay be assigned. [(Call strike price – initial stock price) – net debit] × 100. Inthis example, the maximum proﬁt is $452: [(55 – 50.18) – .30] × 100. How-ever, the ﬁnal proﬁt is $312.Breakeven: Initial stock price + [(put premium – call premium) (cid:1) numberof shares]. In this case, 50.48: 50.18 + [(330 – 300) (cid:1) 100].
Margin: Check with broker.
STRATEGY ROAD MAPS
Long Butterﬂy Spread Road Map
In  order  to  place  a  long  butterﬂy  spread,  the  following  14  guidelinesshould be observed:
1. Look for a sideways-moving market that is expected to remain within
the breakeven points.
2. Check to see if this stock has options available.3. Review  options  premiums  per  expiration  dates  and  strike  prices.Make sure you have enough option premium to make the trade worth-while, especially considering the commission fees of a multicontractspread.
4. Investigate  implied  volatility  values  to  see  if  the  options  are  over-
priced or undervalued.
5. Explore past price trends and liquidity by reviewing price and volume
charts over the past year.
6. A long butterﬂy is composed of all calls or all puts with the same expi-ration. Buy a lower strike option (at the support level), sell two higherstrike options (at the equilibrium point), and buy one even higher op-tion (at the resistance level).
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7. Look at options with 45 days or less until expiration.8. Determine the best possible spread to place by calculating:
• Limited Risk: Limited to the net debit paid on the options.• Limited Reward: Difference between highest strike and the shortstrike  minus  the  net  debit.  Maximum  proﬁt  is  realized  when  thestock price equals the short strike.
• Upside Breakeven: Highest strike price – net debit paid.• Downside Breakeven: Lowest strike price + net debit paid.• Return on Investment: Reward/risk ratio.
9. Create  a  risk  proﬁle  of  the  most  promising  option  combination  andgraphically determine the trade’s feasibility. The risk curve of a longbutterﬂy  shows  a  limited  reward  inside  the  breakevens  and  limitedrisk outside the breakevens.
10. Write down the trade in your trader’s journal before placing the tradewith your broker to minimize mistakes made in placing the order andto keep a record of the trade.
11. Make  an  exit  plan  before  you  place  the  trade.  For  example,  if  thestock  begins  to  move  outside  the  breakevens,  consider  cutting  yourlosses. You want the stock price to stay within a range so that you getto keep most or all of the credit.
12. Contact  your  broker  to  buy  and  sell  the  chosen  options.  Place  thetrade as a limit order so that you limit the net debit of the trade.13. Watch the market closely as it ﬂuctuates. The proﬁt on this strategy islimited—a  loss  occurs  if  the  underlying  stock  closes  outside  thebreakeven points.
14. Choose an exit strategy based on the price movement of the underly-
ing stock:
• XYZ falls below the downside breakeven: Let your position ex-pire worthless. The cost for this trade will be the net premium paid(plus commissions).
• XYZ falls within the downside and upside breakevens: Thisis the range of proﬁtability. Ideally you want to sell the long optionsand let the short options expire worthless. The maximum proﬁt oc-curs when the underlying stock is equal to the short strike price.• XYZ rises above the upside breakeven: Either exit the tradeor  if  you  are  assigned  the  short  options,  exercise  your  long  op-tions to counter.
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Long Condor Spread Road Map
In order to place a long condor spread, the following 14 guidelines shouldbe observed:
1. Look for a sideways-moving market that is expected to remain within
the breakeven points.
2. Check to see if this stock has options available.3. Review  options  premiums  per  expiration  dates  and  strike  prices.Make  sure  you  have  enough  option  premium  to  make  the  tradeworthwhile, especially considering the commission fees of a multi-contract spread.
4. Investigate  implied  volatility  values  to  see  if  the  options  are  over-
priced or undervalued.
5. Explore past price trends and liquidity by reviewing price and volume
charts over the past year.
6. A long condor is composed of all calls or all puts with the same expi-ration. Buy a lower strike option (at the support level), sell one higherstrike option, sell a higher strike option, and buy one even higher op-tion (at the resistance level).
7. Look at options with 45 days or less until expiration.8. Determine the best possible spread to place by calculating:
• Limited Risk: Limited to the net debit when the position is placed.• Limited Reward: Difference in strike prices minus the net debit
× 100. The proﬁt range is between the breakevens.
• Upside Breakeven: Highest strike price – net debit paid.• Downside Breakeven: Lowest strike price + net debit paid.• Return on Investment: Reward/risk ratio.
9. Create  a  risk  proﬁle  of  the  most  promising  option  combination  andgraphically determine the trade’s feasibility. The risk curve of a longcondor is similar to the long iron butterﬂy; the limited proﬁt zone ex-ists between the breakevens and the limited risk occurs outside of thebreakevens, as shown in Figure 10.3.
10. Write down the trade in your trader’s journal before placing the tradewith your broker to minimize mistakes made in placing the order andto keep a record of the trade.
11. Make  an  exit  plan  before  you  place  the  trade.  For  example,  if  thestock  begins  to  move  outside  the  breakevens,  consider  cutting  your
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losses. You want the stock price to stay within a range so that you getto keep most or all of the credit.
12. Contact  your  broker  to  buy  and  sell  the  chosen  options.  Place  thetrade as a limit order so that you limit the net debit of the trade.13. Watch the market closely as it ﬂuctuates. The proﬁt on this strategy islimited—a  loss  occurs  if  the  underlying  stock  closes  outside  thebreakeven points.
14. Choose an exit strategy based on the price movement of the underly-
ing stock:
• XYZ falls below the downside breakeven: This is in the maxi-
mum risk range. Let the options expire worthless.
• XYZ  falls  within  the  downside  and  upside  breakevens:This  is  your  proﬁt  zone  with  maximum  proﬁt  being  at  the  shortstrikes.
• XYZ rises above the upside breakeven: You will need to close
out the position to ensure you are not assigned.
Long Iron Butterﬂy Spread Road Map
In order to place a long iron butterﬂy spread, the following 14 guidelinesshould be observed:
1. Look for a sideways-moving market that is expected to remain within
the breakeven points.
2. Check to see if this stock has options available.3. Review  options  premiums  per  expiration  dates  and  strike  prices.Make sure you have enough option premium to make the trade worth-while, especially considering the commission fees of a multicontractspread.
4. Investigate  implied  volatility  values  to  see  if  the  options  are  over-
priced or undervalued.
5. Explore past price trends and liquidity by reviewing price and volume
charts over the past year.
6. A long iron butterﬂy is composed of four options with the same expi-ration.  Buy  one  higher  strike  OTM  call  (at  the  resistance  level),  sellone ATM lower strike call, sell one slightly OTM lower strike put, andbuy one even lower strike put (at the support level).7. Look at options with 45 days or less until expiration.
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8. Determine the best possible spread to place by calculating:
• Limited Risk: The difference in strikes minus the net credit re-ceived for placing the position. This is usually a small value andis  the  reason  why  this  trade  is  attractive.  Realize  that  commis-sions  are  not  calculated  in  this  example  and  can  really  eat  intothe proﬁts.
• Limited Reward: Net credit received on placing the position. The
proﬁt range occurs between the breakevens.
• Upside Breakeven: Middle short call strike price + net credit.• Downside Breakeven: Middle short put strike price – net credit.• Return on Investment: Reward/risk ratio.
9. Create  a  risk  proﬁle  of  the  most  promising  option  combination  andgraphically  determine  the  trade’s  feasibility.  A  risk  graph  for  a  longiron butterﬂy is very similar to the risk curve of a long butterﬂy, onceagain showing a limited reward inside of the breakevens and a limitedrisk outside the breakevens.
10. Write down the trade in your trader’s journal before placing the tradewith your broker to minimize mistakes made in placing the order andto keep a record of the trade.
11. Make  an  exit  plan  before  you  place  the  trade.  For  example,  if  thestock  begins  to  move  outside  the  breakevens,  consider  cutting  yourlosses.  You  want  the  stock  to  stay  within  a  range  so  that  you  get  tokeep most or all of the credit.
12. Contact  your  broker  to  buy  and  sell  the  chosen  options.  Place  thetrade as a limit order so that you limit the net debit of the trade.13. Watch the market closely as it ﬂuctuates. The proﬁt on this strategy islimited—a  loss  occurs  if  the  underlying  stock  closes  outside  thebreakeven points.
14. Choose an exit strategy based on the price movement of the underly-
ing stock:
• XYZ falls below the downside breakeven: You should exit thetrade to make sure you are not assigned the put side of your posi-tion.  The  calls  can  expire  worthless.  You’re  in  the  maximum  riskrange.
• XYZ falls within the downside and upside breakevens: Thisis  the  proﬁt  range  and  ideally  the  position  expires  near  the  shortstrike prices.
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