Overview

The expiration of our protective collar on the Nasdaq 100 Trust (QQQQ) expires on Friday. This being the case, this will be our last update on this mock trade. In review, we started a mock trade on the Qs a month and a half ago using a protective collar. This strategy allows us to protect the gains we have in a stock without putting out a lot of capital to buy this insurance. This is done by buying puts to protect the gains and selling a call to offset the cost of the puts. The risk is that if the underlying sees sharp gains, we would not be able to participate.

QQQQ Mock Trade

When we entered this mock trade, the CBOE Market Volatility Index ($VIX) was trading near support. For this reason, and the fact stocks had been on a rally for six months, left us weary of a correction in the stock market. We did get a correction, although the declines weren't as severe as they could have been. Below is the data about the collar we entered on the Qs as the trade progressed. 

Jan. 25, 2007
Bought 500 shares QQQQ @ 36.03 
QQQQ @ 43.73
Current Profit = $3,850 (43.73 – 36.03) x 500
Buy 5 March 43 puts @ 0.75
Sell 5 March 45 calls @ 0.65
Total debit = $50 (0.75 – 0.65) x 500
Max profit = $4,435 
Min. profit = $3,435

Feb. 8, 2007
Bought 500 shares QQQQ @ 36.03 
QQQQ @ 44.45
Profit in Shares Before Collar = $3,850 (43.73 – 36.03) x 500
5 March 43 puts @ 0.30 (bid)
5 March 45 calls @ 0.75 (ask)
Collar debit = $50 (0.75 – 0.65) x 500
Total debit for collar and stock = $18,065.00
Current Profit = $3,945.00
Max profit = $4,435 
Min. profit = $3,435

Feb. 20, 2007
Bought 500 shares QQQQ @ 36.03 
QQQQ @ 44.68
Profit in Shares Before Collar = $3,850 (43.73 – 36.03) x 500
5 March 43 puts @ 0.15 (bid)
5 March 45 calls @ 0.80 (ask)
Collar debit = $50 (0.75 – 0.65) x 500
Total debit for collar and stock = $18,065.00
Current Profit = $3,950.00
Max profit = $4,435 
Min. profit = $3,435

March 1, 2007
QQQQ @ 43.13
Profit in Shares before Collar = $3,850 (43.73 – 36.03) x 500
5 March 43 puts @ 0.66 (bid)
5 March 45 calls @ 0.15 (ask)
Collar debit = $50 (0.75 – 0.65) x 500
Total debit for collar and stock = $18,065.00
Current Profit = $3,775.00
Max profit = $4,435
Min. profit = $3,435

Mar. 8, 2007
QQQQ @ 42.97
Profit in Shares before Collar = $3,470 (42.97 – 36.03) x 500
5 March 43 puts @ 0.51 (bid)
5 March 45 calls @ 0.03 (ask)
Collar debit = $50 (0.75 – 0.65) x 500
Total debit for collar and stock = $18,065.00
Current Profit = $3,660.00
Max profit = $4,435
Min. profit = $3,435

Mar. 14, 2007QQQQ @ 42.99Profit in Shares before Collar = $3,480 (42.99 – 36.03) x 5005 March 43 puts @ 0.29 (bid)5 March 45 calls @ 0.01 (ask)Collar debit = $50 (0.75 – 0.65) x 500Total debit for collar and stock = $18,065.00Current Profit = $3,570.00Max profit = $4,435 Min. profit = $3,435

Figure 1: Risk Graph of Mock Collar Trade on Qs

Traders could get out of the collar now and make a little more than profits from the Qs alone. If the Qs close between 43 and 45 on Friday, nothing will happen, as both options will expire worthless and the trader would be left with long Qs. If the Qs fall below 43, there are some choices that need to be made.

By owning a put that is in the money, we can either sell the put or exercise the option. If you want to keep the shares of the Qs you own, then selling the put is the way to go. If you want to get rid of the shares, you can put them to someone for $43 a share. This is why it doesn't make sense to exercise if the Qs are trading at or above $43. Currently, there is 28-cents of time value in the Mar 43 puts. However, as expiration approaches, this time value will erode, leaving only intrinsic value.

Conclusion

This example used the Qs, which might not have been the best choice. The broader indices do not see as large of declines as individual stocks, but the concept is the same. I am sure there are many traders that wish they had used this type of strategy with many of the sub-prime lending stocks including New Century.

Overall, though we give away some upside potential when using a protective collar, it sure is nice to have insurance on a sharp decline without needing to may much of a premium. If anyone has any questions on this strategy or would like to make suggestions for future "Real-World" articles, please post them on my forum.

To read previous installments of "Real-World Trading," please click here.


Jody Osborne
Senior Writer & Options Strategist
Optionetics.com ~ Your Options Education Site
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