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Notice IBM stock closed at $126.00/share, up $2.51 from the
previous trading day. Let’s say we are bullish about the stock but we are
not so sure, so we do the Collar Spread strategy. We buy IBM stock at
$126/share, buy December 125 Put IBMXE for $3.05/share and sell December
130 Call IBMLF for $1.70/share.
Think of it this way:
1.
Buy the stock Buy
the asset
2.
Buy ATM Put Insure
it
3.
Sell OTM Call Finance
it
If IBM closed above $130 by December 18th, we make
$2.65/share profit ($1.70 + $4 - $3.05).
Let’s see what happen if we are wrong and IBM drops to $120/share
by December 18th:
·
With Put Insurance, the total loss is
$2.35/share ($1.70 - $3.05 - $1).
·
Without Put Insurance, the total loss is
$4.30/share ($1.70 - $6)
With put insurance, our maximum loss is $2.35/share regardless of
how badly the stock drops. We can see the put insurance protects us from
a bigger loss if we are wrong in our forecast.
This strategy is a bit complicated for beginner to understand and
apply. Skillful and experienced option traders use this strategy to make
themselves “bullet proof” after selling several covered calls and buying
put insurance at the right moment. Chart reading ability is a must to
achieve this goal.
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