Collaring the volatile stock

Posted on February 10th, 2012

As our readers know, the collar is one of our favorite hedging techniques. In a taxable account, the collar permits the investor to be more tax efficient since the underlying stock (or ETF) can be held without a sale for as long as the investor desires. This can generate a potential for long-term capital gains tax treatment.

But if your investment appetite leans towards the more volatile stocks or sectors, do you need to adjust your approach to building the collar? The short answer is: yes! The longer answer is: especially yes if you invest in volatile stocks looking for the big payday.

You already know the collar is when you own the underlying stock and pair it with a long put (usually out-of-the-money) and a short call (usually also O-T-M). But picking the downside protection level can be tricky. Picking the upside call strike can be even trickier.

We have a few recommendations if it is a stock more volatile than most – or if the stock is prone to sharp moves around earnings season.

First, if it is volatile, the time value will reflect that volatility in the price of the OTM put. So, you might want to consider setting your protection level at a slightly lower strike price than usual. After all, if you are comfortable owning a volatile stock to begin with, then less downside protection should fit you like a glove.

Second, think about the cost of the puts on a monthly basis. If the put you buy is set to expire in 6 months, then divide its cost by six. If 4 months, then divide by four. You get the picture. Compare that monthly cost to the O-T-M call you are looking to sell for the near month. Look for the calls that are priced just a little bit less than the per month cost you just calculated. In other words, look for a net cost of being hedged that will be around 1-2% annualized. If it is a good stock – but volatile – and you really like it (but want to be hedged), then don’t be afraid to structure with that slight cost.

The result of technique #1 & #2 above is a wider range of possible prices before your strikes might get hit. But that is OK – as long as your hypothesis for the volatile stock is strong and optimistic. (Side note: if you are invested in a volatile stock and your hypothesis is NOT strong and optimistic, … then WHY ARE YOU INVESTED IN IT?)

A third consideration for collaring volatile stocks has to do with earnings season. If the stock has a tendency to really move on news at earnings (either its earnings or its near competitors), then consider removing the call a week before earnings season. Then, wait for the earnings news to shake the stock price. After that, you can put the call side of the collar back in to play.

Look at Apple’s recent earnings announcement. It was maybe the single biggest surprise to the upside ever announced (certainly since it was measured in Billions of $$$). The stock really popped on that news. There were not a lot of signs pointing to that move. Apple doesn’t really have competitors that could have signaled that it was coming. But almost any calls sold in the prior month would have ended up in the money. You would feel a little sick in the stomach on that gain that you gave up. For Apple, consider avoiding the calls that expire after earnings announcements.

Also, there is another consideration for you if you like volatile stocks: maybe just invest in the married put. I realize the time value in options on volatile stocks are really expensive (relatively speaking). And I realize that the call helps to offset that cost. However, if you have a VERY strong hypothesis about this volatile stock and you want to capture all of the upside, then consider just the married put approach.

Of course, you can always consider hedging using the sector ETF for the stock as a cheaper alternative. But that approach changes the risk dynamic of the investment. We wrote about that in a prior blog post here.

All in all, we like collars a lot. For volatile stocks that you think you will own for a long time (more than 1 year), the collars are a recommended hedging tactic. Just think about these techniques to adjust your approach.

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