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A zero-cost reverse collar is an excellent long-term strategy in a bear market, because it allows a short position to be maintained and protected for little to no cost.
How is it established?
The trade has three separate elements:
- A short position in the underlying stock.
- A long at-the-money LEAPS call that acts as insurance against a sharp move higher in the shares.
- A short out-of-the-money LEAPS put that finances the cost of the call.
The strategy is more defensive than aggressive, as the upside is capped by the short put option. But no less important is the full coverage against loss on the underlying shares via the long call.
Let’s have a look now at a real-life trading example to better understand the zero-cost reverse collar’s profit potential and limitations.
Below is a chart of telecom juggernaut AT&T (NYSE: T) for roughly 18 months:
It’s early March, and AT&T has just made a quick surge higher that you believe is overdone. You contemplate shorting the stock, confident, too, that an extended move lower is in the offing. New regulations and a number of strategic moves by competitors only add to your conviction that the proverbial fat lady has sung.
But there remain a few nagging doubts. One is the recent strength of the stock, a phenomenon that your research suggests could carry for a few months yet. The other is the general strength of the market, which would likely serve to buoy the stock even if AT&T were in genuine trouble.
After discussing it with your broker, you decide to go ahead with the short – with a few modifications. He suggests a zero-cost reverse collar, a trade that allows you full protection in the event of a spike in the shares, as well as a reasonable gain if you’re right and the stock declines.
Setting the Trade
The short sale is transacted at exactly $36, and a LEAPS call roughly 11 months out is also purchased – the January 36 strike, for $4. Rounding it out, you sell the January 33 put for the same $4 (black squares).
And you’re glad you did, because AT&T immediately gains close to 10% in a straight climb to $39 that would have sent you manically searching for antidepressants had you not set the collar. You’re 100% protected by the long call, and that feels good.
In the end, though, the gains for AT&T are short-lived. Within weeks of the highs, the stock is again trending lower and closes at $33.50 as the collar expires in January (blue circle).
Your profit on the trade is wholly based on the short sale, since both options expire out of the money. The gain is $250 ([$36 – $33.50] x 100), or 6.9%.
Had the shares dropped below the short put strike of 33, your gains would have been capped at $300 ([$36 – $33] x 100).
A 95% Success Rate
It’s as close to perfect as anything you’ll find in this world. It’s the ultimate trading system—one handing you double-digit returns in just seven days. In and out. Just like that. It’s the fastest, easiest money you’ll ever see. Find out how right here.