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Twitter A call spread collar is constructed in the exact same manner as a reverse collar, with one exception: the call purchase is replaced with a call spread.
Why would anybody do that, you ask?
Well, with a normal reverse collar, the trader buys a protective at-the-money call to ensure against a loss on the trade and, at the same time, sells an at-the-money put to offset the cost of the call.
The problem with that structure, however, is that it necessitates both the call and put be set extremely close to one another, handcuffing one’s ability to make money on the trade. By selling an additional call option some 10% to 20% out of the money – as one does with a call spread collar strategy – the trader is no longer forced to place the options so close together.
Because two options are now carrying the cost of the long call, the short put strike can be lowered significantly, thereby enabling a significantly greater margin of profit should the stock continue to slide.
In essence, the call spread collar serves to widen the risk/reward profile of a traditional reverse collar, allowing for greater losses on the trade, to be sure, but also opening the door to greater gains.
Component Parts
A closer look at the individual parts of the trade will give us a better idea of how the strategy works.
It goes like this:
- First, one sells short 100 shares of the underlying security.
- Second, one purchases a protective at-the-money call.
- Third, one sells an out-of-the-money put and an out-of-the-money call.
Now have a look at a genuine trading example to better understand the intricacies of the trade.
This is a chart of BP PLC (NYSE: BP), a stock that has been in decline for a while, along with the rest of the oil and gas sector:
With no end sight for crude oil’s bear market, you decide to short sell BP and make some cash on the retreat.
With the shares at $40 you go short (red circle), and things look good – at first.
A month later, however, the stock has bounced higher to your short sale price, and you’re wondering whether it’s advisable to close up shop.
Your broker is also bearish on both oil and BP and therefore suggests you consider a call spread collar, a move that will limit your downside but still leave you some profitability on the short if you’re right.
You go for it.
At the end of January, with BP trading at exactly $40 (blue circle), you buy one protective at-the-money September 40 call for $7 and sell two options to pay for it: the September 35 put for $3.50 and the September 44 call for $3.90. Your total credit on the trade is $0.40 (all options strikes in black boxes).
Patience, Squire!
The stock immediately levitates to $42 and eventually to $44 before turning lower. You’re comfortable knowing that you won’t experience any loss until beyond the $44 mark, as you’re protected until that level by your long 40 call – and beyond that mark by your initial $0.40 premium. Your upside break-even is therefore $44.40, and thankfully, the stock never breaches that line. Should it climb higher than that level, you stand to lose a theoretically unlimited amount.
By mid-July, however, the short sale is profitable again, and by September’s expiration, BP closes in the money at $31, your short is closed via the short put, and your profit breakdown is as follows:
- The call spread expires worthless.
- The short sale is up $500 ([$40 – $35] x 100).
- And your initial premium adds a $0.40 kicker.
That’s the maximum gain for the trade (short sale price, less short put strike, plus initial premium).
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