Q&A

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Explore Your Options

Got a question about options? Tom Gentile is the chief options strategist at Optionetics (www.optionetics.com), an education and publishing firm dedicated to teaching investors how to minimize their risk while maximizing profits using options. To submit a question, post it on the STOCKS & COMMODITIES website Message-Boards. Answers will be posted there, and selected questions will appear in future issues of S&C.

Tom Gentile of Optionetics

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THE COLLAR VS THE BULL CALL SPREAD

I know that owning shares of stock and a put option are equivalent to simply holding a call option. If so, then the collar should represent the equivalent of the bull call spread. Since collars require so much more capital, why do many investors prefer the collar over the bull call spread? Wouldn't it be better to use a bull call spread and then get the interest from a money market account?

Great question. You are absolutely correct that buying shares and a put is the synthetic equivalent of owning a long call. If you buy 100 shares of stock and one put option, the risk and reward from the position is going to be the same as buying one call option. Both will feel the same impact from time decay, both have limited risk and limited reward, and both will generate profits from a move higher in the stock price.

If shares of stock and a put represent the equivalent of simply buying a call option, then it stands to reason that a collar is similar to a bull call spread. The collar is really a combination of a protective put and a covered call. To create the trade, the strategist buys (or already owns) stock, buys puts, and sells calls. In terms of risk and reward, the position is the same as a bull call spread, which is created by purchasing a call and selling a call with a higher strike price.

Obviously, the big difference between the collar and the bull call spread is that one position holds shares and the other does not. As you correctly point out, the shares will require the strategist to put up a lot more capital. So if the strategist is strictly trying to participate in a move higher in the stock over the life of the options, the bull call spread makes more sense. It requires less money to initiate and will produce the same results, or slightly better if that excess cash earns interest in a money market.

However, if the goal is to protect an existing stock position, the collar is certainly an appropriate tool. The put will protect the investor from a move lower in the stock. At the same time, the sale of the call will help offset the cost of buying the protection. The downside is that if the stock makes a big move higher, the call will likely be assigned and the investor will be asked to give up his or her shares of stock (at the strike price of the call option). This, however, is also true of the bull call spread. If the stock makes a big move higher, the gains are limited by the short call with the higher strike price. In both the collar and the bull call spread, the sale of the call with the higher strike price helps offset the cost of the trade.

The collar also makes more sense when the strategist wants to accumulate shares over the long term, which is a strategy currently being taught by some of our instructors. It is a more advanced strategy and requires a bit more capital. The goal is to continually adjust the position as the share price moves higher and lower. Doing so allows the investor to increase the number of shares owned over time. For that reason, many traders start with bull call spreads until they build up enough capital to start actively trading collars.

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SELLING OPTIONS

I heard that 80% of all option contracts expire worthless. If this is true, why would anyone buy an option? Isn't it better to sell options?

Over the years, I've heard this question often. The percentage of options that expire worthless is actually much less than 80%. It is probably closer to 40%, or half that. Many contracts are closed out well before expiration through offsetting transaction. You can close out a long or short call any time prior to options expiration. Other contracts are exercised.

At the same time, there are opportunities to profit from the fact that many contracts do expire worthless. The covered call, or "buy write," is one of the more popular strategies. It simply involves holding shares and selling calls. If the stock doesn't move, the calls with a strike price above the current market price of the shares will expire worthless and provide income into the portfolio. At expiration, the strategist can sell more calls and generate even more income.

Selling uncovered calls involves a lot more risk, and most brokerage firms do not allow this type of trading without a certain net worth and a number of years of trading experience. The credit spread is an alternative and is suitable when the strategist wants to sell options, but limit some of the risk. For example, if you expect a stock to fall in price, you can create a bear call (credit spread) by selling a call and then buying a call with a higher strike price. The long call will protect you if the stock makes a sudden unexpected move higher. If it stays flat or falls, however, you keep the premium from selling the call with the lower strike price (which will be greater than the call you purchased). It is the opposite of the bull call spread discussed in our first question ("The collar vs. the bull call spread").

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Originally published in the April 2008 issue of Technical Analysis of STOCKS & COMMODITIES magazine. All rights reserved. © Copyright 2008, Technical Analysis, Inc.

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