Saturday, December 5, 2009

Options Action- GLD Collar

Gold was in the spotlight during Friday night's Options Action. For those currently long GLD stock and fretting over a continued sell-off from Friday's ugly price action, entering a zero cost collar was suggested. Basically the zero cost collar offers downside protection while limiting upside profit potential. Let's break it down.

Existing Position: Long 100 shares of GLD at $100 entry price
New Positions: Sell the Jan 120 call option for $1.75, Buy the 108 put option for $1.75
Long Stock
[Source: EduTrader]

The collar consists of simultaneously selling an OTM call option and buying an OTM put option. It can be thought of as selling a covered call and buying a protective put. The put option locks in the right to sell the stock at the strike price, thereby limiting the downside risk. The call option obligates you to sell the stock at the strike price, thereby limiting the upside profit potential.

The premium received from selling the call option helps to finance the purchase of the downside put. If you sell the call for enough premium to purchase the put, it is often referred to as a zero cost collar. The example used during Options Action was a good example. The $1.75 received from selling the Jan 120 call was enough to pay for the Jan 108 put option.

Collar trades can be a legitimate way of adjusting an existing profitable long stock position. As a prerequisite you would need to be willing to cap your upside in exchange for limiting downside. As far as timing goes, I would considering entering collars if I was anticipating unstable markets or a looming sell-off in my individual stock. In hindsight, last Thursday would have been the ideal time to enter on the GLD as it would have given some protection for Friday's downdraft.

For other related Options Action posts, check out: