Recently the equity indexes reached all-time highs and then pulled back (as of August 22) by about 4%. Meanwhile, the price of gold seemed to have bottomed out at multi-year lows in June, and has recovered about a quarter of what it had lost since it made its 2011 highs.
Investors in both gold and equities had reason to be bullish but cautious. Options strategies give us multiple ways to take advantage of further upside moves while limiting our risk. When choosing a strategy, we should be aware of the different ways to accomplish what we’re trying to do.
Let’s look at the gold ETF, GLD. Its chart is shown below. As of August 22 it stood at 133.15. It was rising into an area that had been the origin of the last major down leg in June.
Figure 1 – GLD
Although the trend was strong, the significant resistance at this level was worrying to gold investors. If the price did break through this level, it looked as if it could reach around 140 within a few weeks.
Was there a way for an investor who already held GLD to preserve most of the profit gained to this point, and still participate in a further move if it happened? Would I have asked the question if not?
One way to gain a limited amount of downside protection is to sell call options against the long position. On 8/22 we could have sold the September 140 calls for $.71. This would in effect reduce our cost of the GLD position by $.71 per share. We could then withstand a drop of up to $.71 without losing any of our profits to date. If GLD did continue up, we would still participate, up to the $140 strike price. When the September calls expired, we could then sell more calls at higher prices, and so on. Covered calls are a great income-generating device, and they do help us to whittle away at our average cost month after month.
All of this would only make any sense if we expected GLD to continue moving up. If we didn’t believe that it would, of course, we would simply sell it, pocket our profits, and not bother with any of this.
An investor who was only mildly apprehensive might be satisfied with that $.71 of extra cushion. But GLD has shown it is quite capable of making breathtaking drops much larger than that. A covered call provides only very limited protection, in the form of cost reduction. We are still exposed to drops that are larger than that. Could we do anything to get more protection?
The Straight Collar
One popular way to do just that is by using a Collar. In this strategy, we use the cash generated from selling calls, to help us pay for an insurance policy. This insurance is in the form of put options. We could have bought September 130 put options for $1.94 per share. This would guarantee that if GLD made another of its gut-wrenching drops, we would always be able to sell at no less than $130. This would limit our loss to no more than the current price of $133.15, less the guaranteed resale price of $130, or $3.15. We would be paying a net price of (put premium minus call premium) = ($1.94 – $.71) = $1.23 for this insurance. In the worst case, we could lose the $3.15 in addition to the $1.23 net insurance cost, for a net loss of $4.38 per share. We could not do worse than that, even if the price of GLD dropped to zero. You could say that our net premium for our insurance policy was $1.23, and the deductible on the policy was $3.15.
Below is a payoff diagram of a collar position with these components. The individual option prices and other data are at the bottom of the diagram.
Figure 2 – GLD Collar diagram
Notice the Max Gain-Loss columns under the diagram. With this position, our maximum loss was $438 per hundred shares of GLD, or about 3.3% of its $133 price. We would incur this max loss only if GLD were below $130 at the September expiration.
If GLD stayed put, the call and the put would both expire worthless. In that case we would have paid the $1.23 for our insurance policy, and not had to “make a claim” (sell our GLD at a further loss of up to $3.15).
If GLD did continue up, we could make up to a maximum profit of $5.62 per share. Having sold the 140 call, we would be obligated to sell the stock at $140. This would represent a gain of $140-133.15 = $6.85. From this, we have to subtract our $1.23 net insurance cost, leaving $5.62.
If you’re familiar with option payoff diagrams, you may have noticed that the one above looks just like another familiar one – the bullish vertical spread. In fact, it is the equivalent of exactly that – a 130-140 vertical spread. The long stock plus the long 130 put together are the synthetic equivalent of a long 130 call. That long 130 call, plus a short 140 call, would together be a Bull Call Spread.
Below is the payoff diagram for the Bull Call Spread:
Figure 3 – GLD Spread diagram
Note that this spread gives almost the same max gain and loss – $596 gain and $404 loss – as the collar’s $562 and $438. Its diagram is nearly identical to the collar, as is its P/L at any price of GLD. A major difference, though, is the capital tied up in the two positions.
The collar ties up the whole $13,315 value of the 100 shares of GLD stock; plus the net “insurance” cost of $123, for a total of $13,438.00.
For the bull call spread, we need only $475 to buy the 130 call, and from that we can subtract $71 received from the sale of the 140 call, for a net out-of pocket cost of only $404.00.
Given these alternatives, it seems obvious that a good move would be to sell out our GLD at its current price, pocketing $13,315; and then buy the bull call spread with just $404 of that money. We’d retain the same upside and limited risk as if we had used the collar. We’d also get to collect interest on almost $13K of cash, or use it elsewhere in another position.
The last difference is this: The options expire, and GLD does not. If we use the collar, we would probably still have the GLD stock in our hands after expiration. With the bull call spread, we would just have cash. Same profit or loss, just a different configuration of our portfolio when the options expire.
The Diagonal Collar
So the Collar strategy is a way to make a bullish bet with limited risk while continuing to hold a long position in the stock. Next I’ll extend that example and describe how you can modify it to make it work better.
The regular Collar strategy includes three components:
a. A long stock position
b. A long out-of-the-money put, to protect the stock
c. A short out-of-the-money call, sold to bring in cash to help pay for the put
In this strategy, the put option is bought to bomb-proof the stock position. It is an insurance policy. The call is sold to help pay for that insurance policy. Selling the call puts an upside cap on gain to be realized from a price increase for the stock.
Previously we started an example with GLD on August 22.
Now let’s update this position by a week, and see what else we could have done.
A week after the original example, on August 29, GLD was at $135.70. The September 130 put was at $1.05. The September 140 call was at $1.31. At that point, our P/L looked like this:
We had so far made $1.06 in a week, on an advance of $2.55 in the underlying. If GLD held steady at $135.70 until expiration, we’d make another $.26 ($1.31 – 1.05), as both the put and the call lost all of their remaining value. We would not get the full amount of the increase in GLD – but then we would not have potentially unlimited losses, either.
So far, so good.
In this position so far, we bought a month’s worth of time value (in the Put), and we also sold a month’s worth of time value (in the Call). When the September options expired, we would have to renew our insurance policy if we wanted to keep our protection. We could then do another collar, buying an October Put and selling an October call, and so on as long as we wanted to keep doing this.
But not all months’ worth of time value is the same. Options with a long time to live lose their time value very slowly, while those near the end of their lives lose it very fast. We can use this to improve our profitability.
We do this by diagonalizing the collar. Instead of buying a put with just a month to run, we can buy one with several months to run, say 6 months. In this way, our insurance policy doesn’t have to be renewed every month. One 6-month put bought now costs a lot less than 6 one-month puts bought month after month. Just as importantly, that 6-month put costs less than the amount we can get paid for 6 one-month calls. We can make the insurance self-financing, while still profiting partially from further increases in GLD.
Looking for such possibilities as of August 29, there were March 2014 puts (204 days out) at the 130 strike, offered at $5.90. This is compared to the September puts (22 days out) which were then $1.05, as above. While the September puts (and calls) would lose all of their time value as of their expiration on September 20, the March puts would not – they’d still have over 5 months to go. If GLD price and IV remained constant, the March puts would lose only $.36 – a third of what the September puts would lose.
Looking at this another way, the March puts had over 9 times as much time to go, but only cost 5.6 times as much. Our insurance is cheaper when we buy it by the six-pack.
This sounds pretty attractive, and it is. We could conceivably keep our GLD forever with insurance that was very cheap. Not a bad deal.
OK, so what could go wrong?
There are a few things to watch out for. First, we are buying several months’ worth of time value in the puts. If we do this at a time of high implied volatility, then we will pay too much for our insurance. This won’t seem too bad in the first month, since we’ll also be selling calls at a time of high IV. But it will bite later down the line if IV falls. We might not be able to get enough for our future calls to fully pay for our insurance.
So initiating the collar is best done at a time of low IV. Also, the IV levels at any given moment are not the same for all months’ options. The IV of the specific puts that we want to buy might be much higher than that of the front month. In that case it would not be a good time to put on the collar.
Finally, our insured price is the $130 put strike. If the price of GLD should go a lot higher, then our protection becomes less and less effective compared to the price at that time. Of course, we don’t have to keep that 6-month put for the whole six months. We can roll it up to a higher strike at any time. This will cost some money, but always less than the additional profits we’ll already have made if the need to roll it up arises.
With all that in mind, the diagonal collar can be an effective way to maintain a long position with low-cost insurance.