SPY Collar vs. SPX Spread

Posted on February 8th, 2013

 All week we’ve put out pieces about the characteristics of SPY and SPX options. Well finally we’ll get to the right times to use different strategies to create hedged exposure to the broad markets.
SPY Collars:
As a quick reminder, collars are a 3 legged position of long stock, a covered call, and a long put. This strategy will require the determination of 3 prices; one for each leg.
The ETF price will determine the majority of the position gains or losses. The ETF will require full market value purchasing power, as we don’t recommend borrowing on margins This keeps it as an un-leveraged position. SPY has a price of about $150 per share so a single lot will have a base cost of $15,000. This the market value this position controls and is a digestible size for just about any investor. Holding the ETF also allow you to receive a dividend of about 2% a year, which is a nice way to help offset some of your hedge costs. From a tax perspective, holding the underlying position for more than a year is important. Short-term gains can be a killer on any investment, so try to keep it for at least a year to get the 15% long-term treatment.
The put establishes the hedge and defines the downside the position can experience by the distance the strike is out of the money. Buying this put will be the cost of hedging.  If your overall position goes up, the hedge will lose money (as we always hope it does) and you can realize a tax credit for the year. We have seen accounts that have annual gains, but have a negative realized gain/loss for the year because their hedges booked losses and the underlying position was held. Not a bad thing.
The short call is main way we help pay for the put cost. The collar gives you the choice to sell monthly calls or to go out a few months. It’s up to you, but you have to be willing to sell SPY at that level. Selling calls can be a means of generating income as well, but getting too greedy can result in an assignment. In past years, we saw selling 6% above the market to be a pretty safe level, but it really depends on the volatility and delta of the options. So in the low volatility world we live in today, you have to go out a few months for any real premium or get closer with the strikes to the market level. We defer to selling higher strikes with a few more months of expiration. Dividends start to become an issue with call selling. If your calls are ITM at the ex-dividend date, there is a very high likelihood that you will have the shares called away. That is usually a taxable event we are not interested in incurring.
There is one other tactic to note with the collar position. If you think the underlying price of SPY at the time of entry is too high, you can always sell a put spread as a means of generating some income while waiting for your level to be reached.  Think about it as a cash secured put that has its hedge built in already. This is done by selling the put at the strike you want to buy the ETF for and then buy a protective put below it based on your tolerance level. This helps pay you while you wait for a pull back.

SPX Spread
The SPX spreads we’re going to talk about here are verticals and diagonals. As we wrote on Monday, creating bullish exposure can be done by either a debit call spread but can be done just the same with credit put spread. For practical purposed they are going to be the same trade and generate the same risk profile, so we’ll keep this explanation to the calls.
One SPX contract represents about $150,000 worth of market value and although it takes a much smaller amount of buying power to establish the trade, you have to be careful to not unintentionally over leveraging your market exposure. But if you do have an account that has this size, then you can re-deploy all that unused cash into one of the income generating strategies we’ve written about before.  (i.e. JNK credit spreads or NDX High Probability Spreads, etc.). This is an easy way to make more than the 2% SPY dividend if you’re willing to add a little more risk to the portfolio.
This trade is established is by purchasing a call at the level where you want to be hedged (downside percentage from where the market is currently trading) and defines the level where you want your losses to stop if the market goes down. For example, with the SPX trading at 1500 right now a position that wanted a limit of a 10% downside risk should buy the 1350 strike call. Because the call is ITM, there is both intrinsic and extrinsic value in the option premium. The extrinsic, aka time value, is going to be the cost of the hedge. So if the 1350 call is going for $180, this means we have $150 of intrinsic and $30 of time value. Your hedging cost is $30. Unlike the cost of the collar’s put, this hedging cost won’t work out to be deductible as it can’t be separated out.
The short leg of this call spread is sold OTM and can be done at near or mid-term expirations. Since these options are cash settled, there is no ETF to be called away. The trade simply settles as a gain or loss from where the position was opened. When doing this, you’re making the time value on each call you sell if you hold it to expiration. The short call may lose money itself, which every means it went in the money and the intrinsic value rose to a level that was higher than the initial premium generated.  But you have to remember, the intrinsic lost on the short call is gained on the long one. Yes, at some point gains are limited by the upside strike you sold, but you can continually sell calls with time value in them as you roll them to a higher level.
The tactic usually generates more short-term transactions, so that means its not 100% long-term gains as tax events are going to occur more regularly. However as we pointed out on Wednesday, these are 1256 contracts and have a tax advantage treatment that works out to be about a 25% tax rate vs. short-term rates so a tax deferred account may be preferable here.
Here’s how we decide when to use these two investment tactics
  1. If account size < $150k go with SPY collar
  2. If a retirement account go with SPX spread
  3. If you think the market is too high, go with the SPY Collar via selling a put spread to create entry
  4. If you want to keep a larger amount of cash on hand yet have exposure to the broad markets go with the SPX spread
  5. If you want to eliminate the risk of picking the wrong short call strikes, resulting in your ETF getting called away go with the SPX spread
  6. If you need to avoid end of year taxes go with the SPY collar
These are strategies we’ve written about specifically in our Buy and Hedge book, so more info is available there if this interests you. Happy Hedging!

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