There are reasons, sometimes, to hold on to a stock even if you think that the market is in for more pounding. Perhaps you're sitting on profits in a stock you bought years ago and are unwilling to cash in and pay hefty capital-gains taxes. Or, you simply don't wish to miss out on a potential rebound. You may also have no choice if you are a corporate executive who is restricted from selling company shares. If any of this applies to you, an options strategy called a "collar" may be just what you need.
Let's say you own stock in Microsoft (MSFT), whose shares have climbed 41% since December, to trade recently at $56.69. Nonetheless, the software giant's shares are well below their 52-week high of $115, and with computer sales weak, it's possible that Microsoft shares could get clobbered again.
Here's how a collar works. You buy put options that give you the right but don't oblige you to sell the stock at $50. Options are available in various expiration dates up to three years away, but we'll choose the one that runs out finally in January, 2003, giving you coverage for up to 22 months (table). To offset the $825 cost of the put options, you sell call options that allow, but do not require, the buyer to purchase your stock for $75 between now and January, 2003. The net cost of the collar is $37.50, as you earn $787.50 for the calls after commissions. Because the cost of the puts and the proceeds of the call are roughly the same, this strategy is called a "cashless collar."
If Microsoft shares drop to, say, $30 at any point in the next 22 months, you can exercise the puts and collect $50 a share. If the stock instead climbs to $90, the collar may seem less of a blessing because you won't be able to reap the full gain. Under this scenario, you can sell your shares for the $75. The alternative is to buy back the calls so you don't have to sell. That will cost you a stiff $15 a share (the difference between the strike price of $75 and a $90 market price). "A cashless collar isn't always a costless collar," cautions Don Weigandt, a vice-president who advises wealthy individuals at J.P. Morgan Private Bank.
WILD RIDE. Still, if they're done properly, collars enable you to manage risk, especially if you are more worried about future losses than about a dramatic surge in the share price. The collar is an alternative to a common strategy of placing limit orders to protect investors against potential losses in a stock. A limit order instructs your broker to sell a stock when it falls to a preset price. Christopher Cordaro, a financial planner in Chatham, N.J., argues that collars are a better choice than limit orders. "The problem is that a volatile stock might drop just enough to trigger the limit order and then bounce back," Cordaro says.
If you would like to know more about options and collars, check out the Chicago Board Options Exchange's Web site (www.cboe.com). Contracts run up to three years; those that cover a period of more than nine months are known as LEAPS, an acronym for Long-term Equity Anticipation Securities.
Because collars have tricky tax implications, you will probably want to have a financial planner or broker help you execute this strategy. For instance, unless there is at least a 20% difference between put and call strike prices, the Internal Revenue Service might treat the transaction as a sale rather than a hedge, J.P. Morgan's Weigandt says. However, he notes that the IRS has never specified what the band should be.
Since each option covers 100 shares of a stock, you need to have at least that many shares to set up a collar. But commissions are fairly stiff, ranging from $35 to $60 per contract, depending on the brokerage firm. So Cordaro doesn't recommend a collar unless you hold at least $100,000 worth of a particular stock. For chief executives and others with more than $1 million in a stock, investment banks offer customized cashless collars.
Collars aren't totally risk-free. But they can give you some peace of mind in a time of high market anxiety. By Susan Scherreik