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Twitter A diagonal bull collar is set in the same fashion as a traditional collar, with 100 shares of the underlying, a long put and a short call. The only difference lies in the expiry of the options. With a diagonal collar, the long put expires after the short call.
Why use it?
The rationale behind the use of the diagonal bull collar is to create an opportunity for unlimited gains on the trade – a feature not available to the trader of traditional collars.
Indeed, the traditional collar is set up as a conservative profit/loss proposition – both gains and losses are limited. The diagonal variety, as we’ll see below, is instituted to provide free downside protection for a limited time – say, two or three months – after which the possibility of an unlimited gain is created.
As mentioned, setting the trade requires ownership of 100 shares of the underlying. A put is then purchased with an expiry of roughly three months duration, ensuring that any downside is minimized in the event of a sell-off. The short call is simultaneously purchased to offset the cost of the long put. Once the call expires, there’s no limit to the trade’s upside.
Here’s a chart of California-based BJ’s Restaurants (NASDAQ: BJRI) to help us better understand the dynamics of the trade:
You’ve been successfully writing calls against shares of BJ’s Restaurants for some time, but in mid-August, after your shares are called away, you decide to play things a little differently.
Everyone is expecting big news from BJ’s next earnings report in October, though it’s unclear what that news will be. You suspect the stock may be in for a substantial jump higher, but because nothing is certain, you opt to open a diagonal bull collar.
That strategy:
- Puts the shares in your hand, allowing you to participate fully in any coming move higher.
- Offers you a downside protective put through the earnings report (just in case); and
- Pays for the put, via the sale of a near-term call.
At the end of August you open the trade (red circle). You buy the shares for exactly $37, buy one November $34 put for $2.50, and sell one October $39 call for $2.60. Your net debit on the trade is $37.10.
The Wheels of Time Roll Safely Home
As it turns out, the stock meanders sideways through expiration in October, the short call expires worthless, and you find yourself sitting on a free long put – and the shares – with just a week to go before earnings.
Then the news hits.
The stock flies on a substantial earnings beat, and your gain is nearly 30% by the time the put expires worthless in November.
You played it safe, but the added diagonal feature opened up tremendous profit potential that, in the end, found its way into your pocket.
Best- and Worst-Case Scenarios
As mentioned, upside potential on the trade is theoretically unlimited. But if the stock trades above the short call strike before its expiry, the gain is capped at $210 ([call strike – buy price + initial premium] x 100).
Should the stock close below the put strike by that option’s expiry, the loss is capped at $290 ([stock price – put strike + initial premium] x 100).
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