Thursday, October 10, 2013

Collar

In this case, FLG is referring to finance, not menswear.

FLG read an article recommending that people concerned about the looming debt issue use a collar to hedge.  FLG has never really understood the point of a collar.  He's sure there's some circumstance when it would make sense, but he's never thought of one.

For those of you who don't know what a collar is, here's a stylized example.
Imagine you own $100,000 worth of a stock.  Let's say 1,000 shares that cost $100 per share.  You are worried about it falling.  You need to get somebody else to agree that come hell or high water, they'll buy your shares at some price, let's say $90.  So, you buy a put option.  In this example, you buy the option to sell your stock for $90 at anytime during the next three months.  This is the floor of how much you can lose.  It's very much like insurance.  And like an insurance policy, it costs money.  You need to pay the insurance premium.  Where do you get the money?

This is where the collar part comes in.  You don't want to pay the insurance premium out of pocket.  Instead, you sell, to somebody completely different, the right to buy your 1,000 shares at $110 at anytime during the next three months.   And let's say this selling of the right to buy your shares at $110 brings in exactly the same amount of money as it costs to get somebody else to agree to buy your shares for $90 at anytime during the next three months.

A shocking number of people think of this having paid out no money to hedge the downside risk.  No matter what happens, you'll never lose more than $10,000.  But you also traded the upside, as in you'll never make more than $10,000 either.   So, for the next three months you are collared between a $10,000 loss and a $10,000 gain.

Here's what FLG does not get.  When would you want to do this?

If you think the stock is going up, then why limit your upside to $10,000 and why hedge the downside?
If you think the stock is going down, then isn't it better just to sell the stock, get out now, and have $100,000 rather than $90,000?
If simply don't know what it is going to do over the next three months, but want to hold it long-term, then FLG asks why you'd even worry about the next 90 days at all?  Just hold it for the long-term.  Why hedge short-term volatility?
If you want to get out within 90 days, but don't know what's going to happen.  Then, again, just get out now.

FLG can't see a reason to collar any single position.  He could see, maybe, where if you had, say 100 different stocks and knew that you'd have to exit some positions in the next three months, but didn't know which ones in advance, that you might hedge against short-term volatility across the entire portfolio.  Might make sense.

One other argument FLG has heard, is that you might want to make a bet on a stock, but that it's very speculative.  It could swing really up or really down.  You might win or lose big, so you collar to manage the risk.   Here's the thing though.  You could do the exact same thing by making a smaller bet.  Instead of $100,000, do $10,000 or $1,000.  Why put in a large bet, but then collar it?

FLG still doesn't get the collar thing.

No comments:

 
Creative Commons License
This work is licensed under a Creative Commons Attribution-No Derivative Works 3.0 United States License.