Collars for concentrated stock

In short

A friend of mine spent thirty years at one company, and by the end most of his savings sat in its stock. If you are holding a big pile of one stock, you know how he felt. You are proud of it, and a little scared of it too. A collar sets a floor under that stock for a set time, and you pay for the floor by giving up some of the upside. You buy a put option, which lets you sell your shares at a set price, and you sell a call option, which lets someone else buy your shares at a higher set price. The call money pays for some or all of the put. Before you try one, check your broker's approval rules, the tax treatment, and any limits your employer puts on your trading. Then talk to a tax professional who knows your case.

The whole of it

What it is

I once watched a man at a county fair try to carry three pies and a lemonade across a muddy lot. He did not drop one, but he sure did not enjoy the walk. Holding a lot of one stock can feel the same. A collar is like setting down a couple of those pies, though you keep every one of them.

Here is the idea in plain words. You already own shares. You add two options on those same shares. The first is a put, which gives you the right to sell at a chosen price called the strike price. That is your floor. The second is a call that you sell. It gives the buyer the right to buy your shares at a higher strike price. That is your ceiling. Between the floor and the ceiling, you keep going up and down with the stock as before.

Options are contracts, and each standard contract covers 100 shares. The Options Clearing Corporation, or OCC, acts as the clearinghouse for listed options in the United States. The Options Industry Council, which the OCC supports, offers free education on how these contracts work. It is a good place to read before you place a trade.

You may ask why anyone would give up upside. Fair question. A floor costs money, and the ceiling is how you pay. Some people set it up so the two roughly cancel out. People call that a zero cost collar. It is not free, because you pay in the gains you give up.

How it works

If you have ever bought a fire policy on a house, you know the feeling. You pay a little, and you sleep better. A put is something like that policy for your shares. It has a deductible, too, which is the gap between today's price and your floor.

Say you pick a floor below today's price and a ceiling above it. If the stock falls past your floor, you can sell at the floor price, no matter how low the market goes. If the stock rises past your ceiling, the buyer of your call can take your shares at the ceiling price. In the middle, nothing is forced.

Two terms matter here. The expiration date is when the contracts end. The strike prices are the floor and the ceiling. Pick a date that matches how long you want the cover. Longer dates cost more, because there is more time for things to go wrong.

Style matters too. American style options can be used any time up to expiration. European style options can be used only at the end. Many options on single stocks are American style, so the call you sold can be used early. That can happen just before a dividend. Read the fine print first, and you will not be caught off guard.

The numbers, and where to find yours

Every collar has a handful of numbers, and you will find them all in your own account. Look up your share count, your cost basis, which is what you paid for the shares, and the date you got them. Your broker's option chain shows the premiums, which are the prices of the puts and calls for each strike and date. The premium is quoted per share, so you multiply by 100 for one contract.

Some numbers are set by law or by rule, and they change. The tax rates on gains depend on how long you held the shares, and the dividing line for a long term gain is the current figure, which the official source publishes each year days. The rate itself is the current figure, which the official source publishes each year. The extra tax on net investment income for higher earners starts at the current figure, which the official source publishes each year. Your broker may also require margin or special approval, and each firm sets its own level. The level a collar needs is the current figure, which the official source publishes each year at many firms.

For the tax side, the best place to read is the IRS itself. Publication 550, Investment Income and Expenses, covers how gains and losses on stocks and options are treated. It also covers the straddle rules, which deal with offsetting positions. Whether those rules reach a collar depends on the facts of your case. That is a question of tax interpretation. A tax professional who knows your situation is the right person to ask.

A worked example

Let me tell you about Marguerite. She worked at a mid sized company for twenty years and owns 2,000 shares. Her shares trade at 50 dollars each. That makes her stake worth 100,000 dollars, found by multiplying 2,000 by 50. She wants cover for six months and does not want to sell yet.

She looks at the option chain and picks a put with a strike of 45 dollars. The put costs 2.00 dollars per share. For 2,000 shares she needs 20 contracts, since 2,000 divided by 100 is 20. The put costs 2.00 times 2,000, which is 4,000 dollars.

Next she sells a call with a strike of 58 dollars. It pays 2.00 dollars per share. That brings in 2.00 times 2,000, or 4,000 dollars. The put cost and the call income match, so her net cost is 0 dollars before fees. We will leave commissions out to keep the math clean.

Now watch the three outcomes at expiration. First, the stock falls to 35 dollars. Her put lets her sell at 45. Her shares would be worth 45 times 2,000, or 90,000 dollars at the floor, instead of 70,000. The call expires worthless. Second, the stock rises to 70 dollars. Her call is used, and she sells at 58. That gives her 58 times 2,000, or 116,000 dollars. Without the collar, the shares would be worth 140,000. She gave up 24,000 dollars of gain. Third, the stock lands at 52 dollars. Both options expire worthless, and her shares are worth 104,000 dollars.

So her worst case is a 10,000 dollar drop from today, since 100,000 minus 90,000 is 10,000. Her best case is a 16,000 dollar gain, since 116,000 minus 100,000 is 16,000. Those are the edges of her box. She is not wishing now. She knows.

Where it goes wrong

I have a neighbor who fixed a fence once and forgot he had boxed in his own gate. Collars can do the same thing. The ceiling is the part that bites. If your company's stock jumps on good news, you will not share in it past the call strike. That can sting, and it is the price you agreed to pay.

Early use is another snag. The call you sold can be used before expiration, and then your shares may be called away sooner than you planned. A sale like that can bring a tax bill you did not expect. Tax is the biggest trap of all. A collar may change how the IRS views your holding period, and the straddle rules may apply. The answer turns on the facts of your case. Read Publication 550 and ask a professional before you trade.

Check your employer's rules too. Many companies bar staff from trading options on their own stock, and executives often face extra limits. Breaking those rules can cost you a job. A few other things deserve a look. Commissions and bid and ask gaps add up. A collar protects you only until expiration. After that, you are back where you started unless you set up a new one, and that has its own cost.

Questions to answer before you leave this page

Do you know how many shares you hold, what you paid, and how long you have held them? Does your employer allow you to trade options on its stock, and are there blackout dates? Have you read what the IRS says about straddles in Publication 550, and have you asked a tax professional how your collar would be treated? Are you willing to give up gains above your ceiling to buy a floor below you? How long do you need the cover, and what will you do when it ends? Does your broker approve you for the options you need? And what is the one number, the loss you could stand, that would let you sleep at night?