I had a client last week that wanted to take some profits off the table. The market has had a nice run so you can’t blame him. As we write in our book: you’ll never hear us complain about taking profits. Locking in profits is a key part of being a smart investor.
But there is a challenge in locking in profits when you are invested in a Collar. The Collar is the most common technique we recommend at By & Hedge. When you are in a collar, your downside protection is locked in for several months out in terms of expiration. But you are selling the calls (ie, the upside) in the near month to generate premium to pay for the downside protection.
In other words, you have a timing mis-match in your hedged position. In a collar, you paid for protection (ie, an OTM put) that doesn’t expire for a while. And you are paying for it by selling OTM calls every month that expire in only 1 month.
So, in this example, when the underlying investment moves up quickly in value, the put that provides protection loses its value fairly quickly. In fact, it likely has lost more value than the value of the calls that you have sold since you bought the put.
This timing mis-match creates a value mis-match. The underlying investment will be up in value but your loss on the put protection is dragging down the value of the overall collared position.
In this case, you want to take profits. But you can be disappointed that your profits don’t look to be as close to the size of the profits on the underlying. After all, you haven’t sold enough calls to pay for the put protection like you planned. But those puts already lost a lot of their value when the underlying moved up.
Don’t be disappointed. There are techniques you can still deploy that lock in the profit while still generating the necessary call premium to pay off the value of the put you bought originally.
Simply enough: Just sell the deep-in-the-money call for the near month instead of the Out-of-the-money call. Basically, you have now locked in your gain all the way down to the deep-in-the-money call strike price level between now and the next expiration. And you are now market neutral on the underlying. If it goes up a $1, your underlying stock in the collar appreciates a dollar. But the deep-in-the-money call will lose a dollar of value. And vice versa – all the way down to the ITM call strike level.
You have basically went market neutral on the position – but are still collecting some time premium in the call you sold that can help to pay off the put that you bought that expires in the later months.
A few tips to think about when you deploy this technique:
- Remember that you are going neutral on this underlying. So, only deploy this strategy to lock in gains and effectively exit the position without actually ‘exiting’ the underlying.
- When looking for the right strike price on the deep-in-the-money calls, look at the extrinsic value in the call. Make sure you are generating enough to help pay for the OTM put that you originally bought. In other words, think about finding the ITM calls that have the same time premium as the OTM calls you have been selling every month.
- When you have puts that are finally expiring, if you still want to be neutral or out of the position, sell the underlying shares when the puts expire in equal amounts (ie, if 3 contracts expire, sell 300 shares of the underlying also)
- If the underlying investment decreases in value while you are neutral, think about what level you might want to go long again by removing the deep-in-the-money call and selling the OTM calls again. Remember that you already have puts in place so you already have the collar in place and would be hedged as soon as you change from the ITM calls to the OTM calls.
- This technique can be used to delay taxable gains also. You want to exit a position and lock in the gain – but it is October or November. You could use this technique thru the end of the calendar year. That way, your gain in the underlying wouldn’t reflect a sale until the New Year. One important tip to consider: maybe sell the January deep-in-the-money call in that circumstance so that in case the market does dip and your call makes a profit, you won’t have to take that profit until the next year.
- Remember that you still have some risk exposure. You would start to lose value in this position if the underlying loses its value down thru the ITM call strike level that you sold short. You would lose from that level down to the put protection level that you are long. If these strikes are fairly close, that might not worry you too much. But make sure you understand the risk!
So, if you think this market is a little over-bought right now, consider this technique as a way to keep your hedged structure in place while taking your profits off the table.
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