Tags: equity collar, hedging techniques
Gold has been in non-stop rally mode since October of 2008, but after advancing so far (over 150%) so fast, it’s looking a little tired…but has it run out of steam? Considering that the status of the world debt situation along with our own debt problems are far from being resolved, gold bugs have an excellent reason to keep holding the precious metal. But volatility has been coming out of the market and if it continues to drop, so might the price of Midas metal.
So what’s a gold-holder to do? Is there a way of protecting profits while still being able to participate in any further upside?
The answer is “yes” to both questions. The solution that will be presented in this article involves stock options; if you have no options trading experience, either get someone who does to assist you or use another insurance technique such as a simple trailing stop-loss.
What is a collar?
A collar is a cost-effective way to protect an equity position using options. Those with large positions in a single issue, such as corporate CEOs, typically use collars to protect their holdings.
The concept is straightforward: you buy a put with a strike price near the current price of your stock and you sell a call (usually with the same expiration date) to offset the price of the put. This offers you unlimited downside protection (less the difference between the strike price of the put and the stock price) but the sale of the call does limit your upside gains. After a long rally, however, many feel that it’s more important to protect gains than it is to wring more profit out of the trade.
Your choice of collar depends upon your risk tolerance as well as how much insurance you think you’ll need. Before we consider a couple of cases, let’s first determine appropriate strike prices.
Support/resistance levels in the GLD
Selection of appropriate strike prices for our gold collar is best done by looking at its support/resistance levels. Since one of the most popular ways of holding gold is via the GLD, the SPDR gold ETF, we’ll be looking at its chart to determine strike prices.
The GLD has topped out at $185 and has minor support/resistance at the 175 and 165 levels. (Major support levels are at 155 and 145.)
Protect profits with a tight collar
For those of you who have recently bought into gold, protecting yourself from a big loss is probably more important than maximizing your gains. In this case, you’ll want a tight-fitting collar. With the GLD closing the day at $179.10 (at the time of this writing), you could buy the September 179 put for $4.75 and sell the September 185 call for $2.50 for a total net debit of $2.25.
The good news is that you’re immediately protected against any loss while still retaining $6 in upside potential. At September expiration, you’ll realize a gain if the GLD is trading either over $181.35 ($179.10 + $2.25) or under $176.85 ($179.10 – $2.25). If the GLD is trading between $179 and $181.35, you’ll lose the entire cost of your insurance. Considering the recent increased volatility in gold, the chances of it landing in such a tight range in three weeks are pretty slim.
Increase profit potential with a loose collar
For those who have already made a substantial profit on their position, they can try a looser collar. A 165 put/190 call collar offers a lot of upside legroom while protecting against a major price plunge. Using September options, the total cost of this position is $0.77 for the put and $1.44 for the call, giving a net credit of $0.67. In this example, you’re actually getting paid to purchase insurance but in exchange for that, you’ve given up $14.10 of protection. (In options, there’s no such thing as a free lunch unless you’re the market-maker.)
Collar variations
The good thing about using options as a hedge is that you can choose your own risk/reward scenario; the bad thing about using them is that choosing the right scenario can be confusing, even for seasoned options traders. Here are a few variations on the standard collar (September expirations are assumed in the calculations):
1. Laddering the strikes. For example, say you have a nice profit but don’t want to risk giving up a good chunk of it. In this case, you could buy a half put position at the 175 strike for $2.94 and the other half at a lower strike, say 165 for $0.77. Your total cost for the put side of the collar would then be $3.71 which is a savings of $1.04 over the 179 put given in the first example above.
2. Legging into the position. The term “legging” means entering into one side of the collar at one time and the other side at a later date. If you’re worried that gold may drop at any minute, then buy a put as soon as possible and wait until it rallies before selling your intended call. You’ll be getting a higher price for it which will lower your total position cost—you could even turn the collar into a net credit!
3. Using different expiration dates. When using collars, it makes sense to buy a put with a longer expiration date and selling front-month calls along the way, especially if you buy the put during a period of consolidation. You can then wait until gold begins moving back up before selling the call.
Caveat
Although the GLD has a very rich options field, some strikes are more liquid than others. In general, strikes at the $5 and $10 levels have the greatest open interest (this is true for most stocks), and the greater the open interest, the faster your trade will execute, quite often at a more advantageous price.
Conclusion
With the huge run-up in gold, it just makes sense to protect profits. Using a collar is one way to do it. If you elect to try this method, I hope you will consider some of the variations given above.