It is well known that you can hedge a stock by either buying a put or by writing a call on it. What is not so well known is that you can combine these two strategies. This long stock + short call + long put combination is known as a "collar." As we shall show with four different variants, this combination is really very flexible. You will want to test out these various hedges with our Whatifi3.Xls software to find which combination is right for you. In a coming report, we will show you the advantages and disadvantages of a different hedge, the 1-to-1 bear spread.

Hedging with a "Collar"

Usually, when setting up a collar (long stock + short call + long put), you write a near-the-money call on stock that you own and buy an out-of-the-money (i.e. lower strike) put on this same stock. On a net basis, if the call strike price is closer to the stock price than put strike price, you will take in premium. As with a covered call, you can earn money even if the stock stands still. In addition, you will be protected by the put. Even if the stock goes to zero, your loss is limited with this collar to the difference between the stock and the put strike price minus the net premium you took in.

In Graph 1, we show you an example of hedging 100 shares of Apple Computer (stock price = $65.00) by writing an at-the-money July $65.00 call at $4.70 and buying an out-of-the-money July $55.00 put for $0.90. With this combined hedge, we take in a net premium of $3.80 per share ($4.70 minus $ 0.90) or $380 on 100 shares before commissions. (For ease of discussion, we will exclude commissions.)

In the graph, we show the likely "mark-to-market" P/L of these combined positions on three different dates. These dates are (1) the day the position is established (05/16/06), half way to the expiration (06/18/06) and at the expiration of the options (7/22/06). With this collar, your maximum profit is $380 if the stock ends up at $65.00 or higher. The most you can lose in this example is $620 if the stock ends up at $55.00 or below at expiration. In addition, because of the $380 credit, you have a break-even point of $61.12, $3.80 below the current $65.00 stock price.

A "Costless Collar"

Another typical configuration of a collar is what is known as a "costless" collar. Here, you buy an out-of-the-money (lower strike) put on the stock and sell an out-of-the-money (higher strike) call for about the same amount of premium.

Graph 2 shows an example of a "costless" collar. Here we hedged our 100 shares of Apple by writing the January 2008 $75 call for $9.95 and buying the January $65 put for premium of $10.30. This combination gives us a small net debit of $0.35 (or $35 on 100 shares).

Notice the advantage of this costless collar, since you get $1465 worth of upside ($80 Call Strike minus $65.00 stock price minus $0.35 net premium paid) in return for a maximum loss of only $0.35. Often the way option premiums are priced can add to the attractiveness of these "costless" collars. This is especially true for longer-term options when the interest rate factors make out-of-the-money call premiums higher than many put premiums.

A "Diagonal Collar"

You may choose instead to buy a longer-term lower-strike put and sell a shorter-term higher strike call to round out your collar. In Graph 3, we have written the out-of-the-money July $70 strike call at $2.60 and we have bought a January 2008 $65 put at $10.30. This hedge benefits from the slower time decay of the longer-term option. Thus, on the July expiration date, if the stock is still at $65, you will have kept the call's entire premium while the long put will still be worth a large part of its original value (assuming no decline in implied volatility).

One important note about this diagonal hedge: notice that you achieve your maximum profit if the stock price ends up at the short call's $70.00 strike price. Above that strike the gains get narrower, owing to losses in the long put. Indeed, it is possible to actually lose money if the stock rises far enough. Investors should always check their diagonal hedges with our Whatifi3.Xls template to make sure the possible outcomes are acceptable.

A Truly Bearish Collar

You can even construct your collar so that it gives you a bearish exposure to the underlying stock. Graph 4, we have sold a deep in-the-money July $55.00 strike call at $11.35 against the stock and bought a deep in-the-money July $75.00 put at $10.95. These two transactions more than offset the effects of owning the stock, creating a net bearish position. Such a collar can be useful in accounts (such as some IRAs) in which investors are restricted from taking outright bearish positions.

Using Whatifi3.Xls to Graph Hedges

The graphs in this week's report were constructed using Whatifi3.Xls, our option position-evaluating template. See "Introducing Whatifi3.Xls (Ot050214.Pdf) in our Reports Archive. Whatifi3.Xls allows you to evaluate the expected outcomes over three time periods on four separate positions on the same underlying stock. We designed this template to work interactively with our downloadable spreadsheet data. It accurately marks these positions to market, accounting for the spread between the bid and ask prices.