Take the Bite Out of Time Value with Collars

   
Take the Bite Out of Time Value with Collars

A Jan. 6 options trading article from Reuters made reference to an unusual spread trade on the popular S&P 500 ETF (SPY) that was entered early in the trading session. The size was unusual, which made it newsworthy but the three-legged structure was a little complicated.

Although the components of the trade may have been confusing, it is worth digging into as a good example of one of the purposes for option collars — to remove some or all time value risk.

The three components of the spread could actually be divided into two trades. The first was a long, out-of-the-money call with a strike price of $88 and an expiration in February 2009. The cost on that call was probably near $149 per contract at the time the trade closed.

A long call is bullish by nature and has two kinds of risk. The position is exposed to market risk if the stock does not go the direction predicted and time-value risk that may make the position a loser if the market remains flat or does not move far enough in the right direction.

One way to reduce the time value risk component is to sell a spread collar against the long position. The premium received from the short option spread will offset all or part of the time value in the long call.

Quite often the way this is accomplished is to sell a call with a strike price above the long call, however, this will cap the gain potential. Selling a put spread is another way to accomplish this same objective.

In this case, the trader sold a put spread that was also out of the money at the 70 and 76 strike prices with February 2009 expirations. The premium from the put spread offset about 50% of the time value in the long call and left the upside unlimited.

The out-of-the-money put spread has limited the time-value risk, but since both the call and the put spread are directional trades there is still considerable market risk exposure.

There were 50,000 spreads involved in this transaction, and if you looked at the chain sheet on the SPY, volume spiked considerably at the strikes involved in the first full week in January. The size of the trade and the fact that it was a very bullish position is what made this trade newsworthy. It is not every day that a trader takes a $3.5 million bullish position on the SPY these days.

Whether this trader’s forecast is correct is uncertain but it is a good example for using a collar to take some of the sting out of time value. In the video, I will dig into more of the detail behind this trade and start talking about how the components could be modified depending on your own risk tolerance.

Watch the video below to learn more.

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John Jagerson is a contributor to LearningMarkets.com. To learn more about him, read his bio here.

 

This article originally appeared on the Learning Markets Web site.


Article printed from InvestorPlace Media, http://investorplace.com/2009/02/take-the-bite-out-of-time-value-with-collars/.

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