Dynamics of managing a collar trade

It has been some time since I put up my last post. Blame it on my Hawaii trip with my family and the winter and para Olympics held in Vancouver!

Last 2 months I have gathered a number of ideas and a few valuable lessons.

The market broke down in end Jan and threatened to break down further in the beginning of February. Now it has rebounded to a new high.

Such volatility is a test of the robustness of my trading system.

I have found out that I did very well with calendars during the last quarter of 2009. I made a lot of money only to lose >50% of my gains during the break down in end Jan to mid Feb. I do not have the emotional fortitude or the technical skills ( understanding of the effects of volatility and gamma ) to handle such trades consistently. There are lessons I need to learn.

However, I have found that my collar trades did well. It withstood the volatility and end up positive. 90% of my portfolio are collar trades and it held up well.

I manage my collar trades dynamically.

The keys factors to success of this strategy are:

- It allows time for the trade to latch with the fundamentals of the stock
- It effectively tames the volatility of the stock and the market removing emotions of fear and greed.

Normally, I start a trade with the stock or a covered call if I am bullish. Remember, a collar is ultimately a BULLISH trade. Due diligence must be completed on the stock and I am happy with the bullish fundamentals. Technical signals also confirm the bullish entry.

If I start with a stock, I will add a SC pretty soon if the stock does not move in the direction I accept that there is an increased probability that I will be wrong.

Once the stock moves below my cost basis ( stock price – SC credit ), I will add a put for protection. If the stock is deemed to be very bearish, I will add the put slightly ITM and out in time ( up to 6 months or more ). The collar is extremely flexible and there are numerous way to twit it to suit the market conditions.

Once the stock shows signs of stagnancy, I will add a short call or short put depending whether it is stagnating at support or resistance. Effectively, I am paying for the extrinsic value of my long puts with my short options.

Interestingly, I am ending up with a “synthetic double diagonal”. I am not sure there is such a term defined in the theory of options but it contains:

- Long stock ( act as a call )
- Long put out in time
- Short term SC
- Short term SP.

Effectively, it is a covered call and a put calendar.

From here I adjust the trade dynamically.

On bullish signal, roll up the SC. If very bullish, sell the put and let the trade run. Be ready to add back the put if the direction is wrong.

Do not forget also to roll the SC down if the stock becomes very bearish . You need to continue to gain credits from the short calls.

There are times when the trend is very bullish and I will have to allow the SC to be assigned. Most trades with OTM covered call will allow me to exit with my target of more than >30% annual ROI.

In a covered call compared to a calendar, there is minimum gamma effect as you have a stock and not a long call. So you do not need to worry about the SC going ITM. You are assured of a profit even if the SC goes ITM in a covered call. In a calendar, if the SC goes deep ITM, your trade is in trouble.

Often the bullish trend fails, the price falls back to below your SC strike price. You get to keep the credit upon SC expiration and allow further SCs to be executed. I do not need to be very technically competent to manage the volatility and gamma effect but a basic understanding of the Greeks certainly helps.

I must also say that I do not get all my adjustments correct. At times the market surprises me. However, overall the results are positive. Even if the stock price drops 20%, my options trades often more than compensate the drop in value. If the stock goes back up in alignment with my fundamental analysis, it will be pure profits for me again. It allows time for the stock to work in my direction. If the drop is >20%, I will normally add more shares with the profit from my puts if I believe the stock price has bottomed.

I know the above explanation is still very vague and it is difficult to understand exactly how the above strategies are executed without examples. There are many variables but the principles behind the application are the same. Perhaps I will find time later to add some examples to this blog for illustration.

Part of the success depends on the technical system used to activate bullish and bearish signals. No technical system is 100% accurate. But it can give good guidance on your directions and if you are wrong. Your mistakes are mitigated by the option strategies.

Note that the reversed is true for bearish bias stock. Similar principles are applied. You can use a reversed collar, which comprises:

- short a stock
- Buy a protective call
- Sell a put to reduce cost
- If stagnant and faces resistance, sell a call

There are some disadvantages with this strategy. You have to pay the dividend. So I will hesitate to use this strategy on high dividend stocks unless I am very bearish. Secondly, you may have to pay interest for stocks that you borrowed from the broker.

But I have made good money during bearish trends during the Asia crisis in 1997, dot com bust in 2001 and the credit crisis in 2008. These short strategies had allowed me to make some good money on a bearish trend. Instead of merely protecting my position in a bearish trend, I should ride on it to make some money too.