Options Trading Made Easy: The Reverse Collar

The “reverse collar” is the mirror image of the straightforward, vanilla collar strategy.
It’s a tactic that permits traders to:

1. Maintain a long-term short position.
2. Write premiums against it.
3. All but eliminate risk.

The trade consists of three elements:

1. A short position of 100 shares in the underlying;
2. An out-of-the-money short put; and
3. An out-of-the-money long call.

Why Collar a Short Position?

There are costs associated with holding short positions, and if they’re held for a lengthy duration those costs can add up, potentially eating deeply into the profit potential of the trade. Costs include paying dividends (where applicable), paying borrowing charges for the shorted shares, paying interest for any margin on the trade, etc. So by selling puts against his short position, the trader has a chance to recoup those expenses and potentially add to his profit.
The resulting short stock/short put is the inverse of what we know as a covered call and operates in exactly the same fashion, but in the opposite (downward) direction.
But what happens when the trader is baffled about upcoming market direction? What should he do if he wants to maintain his “covered put” position but doesn’t want to endanger himself in the event of a short squeeze?
Answer: He simply initiates a reverse collar by buying an out-of-the-money call.
In so doing, he profits from either a continued slide or a sideways move in the underlying – and minimizes any losses he might suffer should the stock unexpectedly break higher.
Let’s look at a trading example to help us understand the risk/reward profile of the trade.
This is a chart of Dow component United Technologies Corp. (NYSE: UTX):

You’ve been short United Technologies for several months and have successfully sold puts against the position to generate additional income. But by mid-October the stock starts to rally, and you feel the trade may be threatened. When it reaches your original short sale price of $95, you decide to take action (red circle).
You don’t believe the decline is over, so you sell another put, this time the January 90 expiry for $5. At the same time, you guard yourself with a protective call using the January 99 strike, trading at $4. Your net credit on the trade, therefore, is $1.

The Rise Continues

And indeed, your fears are realized as the stock climbs to $100 and hovers there for nearly a month.
With your credit of $1, your break-even for the trade is $96 (original short sale price less premium), after which you stand to lose money all the way to the long call strike of $99, or a maximum of $300 ([$99 – $96] x 100).
You’re willing to suffer that loss, though you’d prefer the stock to reverse, and within a few weeks that’s exactly what happens. The stock sinks directly to $85 by January expiration, bypassing your short 87 put on the way and closing out the short position.
The final tally is a gain of $600, including the initial credit ([$96 – $90] x 100), which is also the maximum take on the trade (price of short sale plus premium, less short put strike). The long call, of course, expires worthless.

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