COLLARS AND CONVERSIONS. ONE IS INTERESTING KNOWLEDGE TO HAVE IN YOUR BACK POCKET. THE OTHER IS HANDY TO HAVE IN REAL, LIVE TRADING.
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strike price of the call is to the current stock price, the
larger the credit you get when you sell it. But it also
limits the potential profit on the long stock position if
you’re lucky and the stock goes higher. The stock’s
profit potential is capped at the strike price of the short
call. Place the short call strike too close to the current
stock price, and you’ll cap the profit on the stock pretty
quickly. Place the short call far away from the current
stock price, and you’ll take in a smaller credit. That’s
Time Because the short call generates positive time
decay, the choice is a balance of the rate of decay and
the total amount of extrinsic value. The amount of
extrinsic value determines the maximum income you
can receive for selling the call. But the rate of decay
determines how quickly the position generates that
income. The more time to expiration, the more extrinsic
value and the higher the credit for selling the call, but
the lower the rate of decay. The less time to expiration,
the less extrinsic value, but the higher the rate of decay.
Balancing those two things will help you determine in
which expiration month to sell the call. The strike also
affects the rate of decay and the extrinsic value.
HOW MUCH INSURANCE DO I NEED?
Because they are similar with regard to risk and potential reward, your approach to determining the strikes
for the options in the collar or the vertical is pretty
much the same. For the put on the collar, which is also
the strike of the long call in the long call vertical, you
determine how much protection you want. If you buy a
put further out of the money, it will be less expensive,
but your stock position will lose more before the long
put protection kicks in to offset the losses. Puts that are
closer to the money provide more protection, but they
also cost more.
One factor is how much you’re willing to pay to
hedge your long stock position. And, as mentioned earlier, the long put doesn’t have to be in the same expiration as the short call. You may want to buy a put in a
further expiration, because while it will cost more (all
other things being equal), it will have lower negative
time decay—as well as more positive vega (the measure of an option's sensitivity to changes in the volatility
of an underlying asset). . If implied volatility rises
when the stock drops, that will drive the value of the
higher-vega long put up that much more.
Collars and verticals are interesting ways to get
started in option trading; they are versatile, provide a
hedge, and can provide income. Now if we could just
find the perfect recipe for chili.
The information contained in this article is not
intended to be investment advice and is for illustrative
purposes only. Multi-legged options transactions such
as spreads, collars, and conversions will incur contract
fees on each leg of the order, which may impact any
potential return. Collar and conversion strategies
involves the risks of both covered calls and protective
puts. Ancillary costs such as commissions, carrying
costs, and fees should be evaluated when considering
any advanced option strategy. Be aware that assignment on short option strategies could lead to an
unwanted long or short position in the underlying security. Clients must consider all relevant risk factors,
including their own personal financial situations,
before trading. Options involve risks and are not suitable for all investors. Supporting documentation for
any claims, comparison, statistics, or other technical
data will be supplied upon request.