Protective Collar Strategy

protective collar strategy options

A Protective Caller strategy is suited for FNO stock investors and Option Writers who are bullish on a stock but would like to eat premiums too. It involves:

a. Buying x number of any FNO stocks that the investor or options writer is bullish on

b. Shorting a Out-of-the-Money call

c. Going Long on a Out-of-the-Money put

YOU SHOULD PLAY THIS ONLY WHEN THE LONG TERM TREND OF THE STOCK IS BULLISH AND/OR THE SHORT TERM TREND OF THE STOCK IS STEADY.

How To Play The Protective Collar (Example)

It’s 4 May 2018, and let’s assume you are bullish on Grasim. The CMP is 1080. In your estimate, Grasim can hit 1,300 in 4 months, but will languish around 1050-1140 in the near term and before the nearest expiry.

One Option lot is 750 shares.

You transact the following:

Buy 500 shares of Grasim at 1080

Sell 1 Lot (750 shares) of Grasim 1200 CE 31-5-18 Expiry at Rs 4

Buy 1 Lot (750 shares) of Grasim 1000 PE 31-5-18 Expiry at Rs 6

SCENARIO 1: Stock remains Steady (corrected on ( May 2020 after comment from Sudhir Kumar)

If Grasim is steady at 1080 before or around the expiry date, then your CE will not be exercised and you will make Rs 3,000 (750 shares X Rs 4). Your PE will remain steady and when you sell it, you may incur a maximum loss of Re 1-2. Let’s assume you lose Rs 5 per share on the PE, and your loss on the PE is Rs 3,750.

In scenario 1, you continue holding on to the stock which you are bullish on, and end up losing Rs 750 by playing the protective collar.

The lesson s that in a protective collar one must not trade in far off OTMs. These should be nearer.

SCENARIO 2: Stock Falls

If Grasim falls to 1020 before or around the expiry date, your CE will not get exercised and you will make Rs 3,000 (750 shares X Rs 4). Your PE will appreciate to about Rs 18.

How did I calculate it to be Rs 18? 

Well I used the Option Premium Calculator here and assumed:

15 days to expiry
7% safe rate of interest (on Bank FDs/Govt Bonds)
30% annual volatility in the price of Grasim (you can play around with the percentage)
1% dividend yield (it is actually lesser)

Now, the options premium calculator threw up a figure of Rs 15 for the put option. However, CEs and PEs in our markets are generally overpriced, so I assumed Rs 18.

protective collar option

So your Put option would fetch you Rs 18 less Rs 6 (cost) = Rs 12 X 750 shares = 9,000

Your total gains from the protective collar would be 9,000 + 3,000 = 12,000.

However the notional loss of the stock price would set you back psychologically. Nevertheless, remember that you have purchased the stock for the long term and therefore the fall should not bother you.

You also can keep playing with the Protective Collar strategy in the next expiry and keep reducing your acquisition cost. Actually, you should keep playing this strategy until the trend for Grasim turns upwards for the short term.

SCENARIO 3: Stock Rises

If Grasim jumps to 1150 before or around the expiry date, your CE will appreciate to about Rs 15.

How did I calculate it to be Rs 15? 

Well I used the Option Premium Calculator here and assumed:

15 days to expiry
7% safe rate of interest (on Bank FDs/Govt Bonds)
30% annual volatility in the price of Grasim (you can play around with the percentage)
1% dividend yield (it is actually lesser)

Now, the options premium calculator threw up a figure of Rs 11 for the Call option. However, CEs and PEs in our markets are generally overpriced, so I assumed Rs 15.

options premium calculator

 

So you will lose Rs 8,250 (750 shares X Rs 11 (CE covered at 15; sold at 4). Your PE will become worthless and you will incur a loss of 3,000 (your purchase cost).

So your Option losses would be 8.250 + 3,000 = 11,250 

However, at this point you may choose to book profits. If so, your profit will work out to Rs 70 (1150 sale price; 1080 purchase cost)) X 500 = Rs 35,000.

Therefore, in this scenario, your net profit will work out to Rs 35,000 (-) Rs 11,250 = Rs 23,750.

When To Play The Protective Collar Spread

  1. When you are certain that a stock will rise in the long run but may remain steady  before the nearest expiry date.
  2. When you expect the results to be good.
  3. Wen you expect an exciting announcement at the forthcoming corporate meeting.

Caution

Square up both options at the same time, preferably 7-10 days before the expiry date. It is extremely dangerous to leave a short call open.

Remember that as time passes and the expiration comes closer, the time value of options erode rapidly. Therefore you must book your profits or losses ahead of expiry.

If you are new to options, create an Excel sheet and enter into mock trades. Play the real market only when you have sort of mastered options.

Image credit: Whimsy & Bold

3 Comments on "Protective Collar Strategy"

  1. Pankaj gupta | May 7, 2018 at 4:14 pm | Reply

    beautifully explained

  2. sudhir kumar | April 11, 2020 at 1:40 pm | Reply

    Your PE will remain steady and when you sell it, you may incur a maximum loss of Re 1-2. Let’s assume you lose Rs 2 per share on the PE, and your loss on the PE is Rs 1,500. How we will loose only Rs 2, CE will not be exercised and you will make Rs 3,000 (750 shares X Rs 4 when stock is steady. kindly explain.

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