Vertical Collar

[MTE]

Quote from iplay1515:

So back to draining the swamp.

When using a collar to insure against an opening gap for a long equity position held overnight, how does one determine the optimum coverage for the least premium?

For example, the equity was purchased at 50 and the current market is also 50 and the intent is to close the collar after the market opens the following day.

What is the recommended process to begin the analysis?
Is there a recommended app. for this analysis?

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Generally, you want the collar to be a zero-cost one, which means that the premium you receive from the call sale covers the premium paid for the put purchase. However, ultimately, it depends on how much protection you want vs. how much upside you are willing to give up. The more protection you want the more upside you'd have to give up.

There is no recommended process, just open up the option chains and have a look at what the market is currently offering in terms of prices for various strikes. Then just pick the combination that best suits you.

I don't know how much options background you have, but it would definitely be very helpful. So if you don't have any background then I suggest educating yourself about the basics of options.

 

[iplay1515]

Quote from MTE:

Generally, you want the collar to be a zero-cost one, which means that the premium you receive from the call sale covers the premium paid for the put purchase. However, ultimately, it depends on how much protection you want vs. how much upside you are willing to give up. The more protection you want the more upside you'd have to give up.

There is no recommended process, just open up the option chains and have a look at what the market is currently offering in terms of prices for various strikes. Then just pick the combination that best suits you.

I don't know how much options background you have, but it would definitely be very helpful. So if you don't have any background then I suggest educating yourself about the basics of options.

I have a good understanding of option fundamentals, but a more limited understanding of combining options, and strategies. At the moment, I am reviewing Greek fundamentals along with basic strategies.

When it comes to the practical solution of multivariate equations, I tend to use Excel in conjunction with VBA to reduce the grunt work and the probability of errors.

My slide rule moved to my desk drawer when I could afford to purchase my first portable calculator.

 

[iplay1515]

When an equity experiences an overnight gap down of 3% of it's previous day's close, do atm options with a 30 day expiration time generally experience a significant change in delta?


Is a true zero cost collar a reality or a desirable goal?

 

[spindr0]

Define "significant".

If the stock drops, the call deltas decrease and put deltas increase unless there is a fair amount of offsetting implied volatility change.

In the big picture, collaring is cost intensive since there are multiple commissions and add'l slippage. It's not something I'd do on an in and out basis unless trading the components. You have to define the specifics of why you're collaring (earnings release, protecting a gain, etc.).

AFAIK, with a collar, desirable means protecting the principal rather than worrying if there's a small debit cost to the collar. As MTE suggested, you need to open up the option chains and have a look at what the market is currently offering in terms of prices for various strikes. Then just pick the combination that best suits you.

 

[iplay1515]

spindr0, the idea of a "zero cost collar" is appealing, but so far, due to the reasons you mentioned above, I haven't been able to find one that works.

Then there is also the matter of limiting the upside potential of the underlying to consider too.

All of this is hypothetical in an effort to gain a better understanding of practical uses of collars by example.

Most of the books I own explain the theory well, but don't offer much in the same manner as those who have actual experience.

 

[MTE]

If your only purpose in limiting overnight gap risk then the most efficient and cost-effective way of doing that is more likely to just not hold the stock position overnight.

When you use a collar you have to pay double commissions and slippage on the way in and then again on the way out, so in the end you may end up losing more on the transaction costs than you could possibly gain by collaring a stock position rather than just closing out at the end of the day.

EDIT:

If you insist on holding the stock position overnight then a better alternative may be just delta-hedging the position using only the puts, for example. You cut the transaction costs in half and being delta-hedged means that in case of a gap your hedge is better than with a traditional collar.

 

[iplay1515]

Quote from MTE:

If your only purpose in limiting overnight gap risk then the most efficient and cost-effective way of doing that is more likely to just not hold the stock position overnight.

When you use a collar you have to pay double commissions and slippage on the way in and then again on the way out, so in the end you may end up losing more on the transaction costs than you could possibly gain by collaring a stock position rather than just closing out at the end of the day.

That would be my preference too, but there are situations where the risk/reward ratios along with favorable success probabilities would be consistent with my trading plan by holding a position overnight.

So in those cases, I would try to find the most economical method of insuring the plan's risk/reward ratio and limiting the downside while continuing to recognize the random nature of even the highest probabilities.

 

[MTE]

Quote from iplay1515:

That would be my preference too, but there are situations where the risk/reward ratios along with favorable success probabilities would be consistent with my trading plan by holding a position overnight.

So in those cases, I would try to find the most economical method of insuring the plan's risk/reward ratio and limiting the downside while continuing to recognize the random nature of even the highest probabilities.

You cannot insure the original risk/reward ratio. Once you add options to the equation (or any sort of hedge for that matter) you change the nature of the position and, thus, the risk/reward ratio. You have to take risk somewhere, otherwise you end up with a risk-free position earning a risk-free return (excluding arbitrage situations).

 

[iplay1515]

Quote from MTE:

You cannot insure the original risk/reward ratio. Once you add options to the equation (or any sort of hedge for that matter) you change the nature of the position and, thus, the risk/reward ratio. You have to take risk somewhere, otherwise you end up with a risk-free position earning a risk-free return (excluding arbitrage situations).

I agree and should have used the term acceptable risk/reward ratio range to include the changes brought on by the addition of the hedge.

While a risk free trade would be nice, my primary objective is to limit my overall risk as much as practical.

 

[KZ Trading]

The idea is that you buy a put for protection and pay for it by selling an OTM call.

You end up collaring your long stock between the 2 strikes until expiration.

Good luck!

kztd