If you are having trouble viewing this email you can view it online here
 


Bill Johnson, Director of Education
at Options University

 August 10, 2007

Q: I have a trading question that no body could answer for me. My question is about the collar (ATM Collar). Here is an example. Today, 2/28/07, the DIA is trading at exactly 123. If I purchase 100 shares of DIA and purchase May 123 put for 2.70 and sell May 123 call for 3.40 don't I automatically lock in a profit of .70 at expiration no matter what the price of the DIA will be? I really appreciate your answer Thank you, Labib.

A: Hi Labib,
Yes, you are correct that you would lock in the guaranteed 70-cent profit by purchasing the stock, selling the call, and purchasing the put. However, before you get too excited about risk-free money, you must measure that return against other risk-free alternatives.

The May options expire on 5/18/07, which is 79 days away from the 2/28/07 posting date of your question. Let's find out what interest rate is necessary to match the 70-cent return and then compare that rate to current market rates. If you invest $123 for 79 days, it would take an interest rate of about 2.6% to yield 70 cents interest. We can find that by solving for i (interest rate) in the following equation: $123 * i * 79/360 = 0.70. If you solve for i, you'll find that it is 2.59%.

Rather than purchase the DIA collar, the above equation shows that you could, instead, take your $123 and place it in a money market for 79 days and get the same guaranteed 70-cent return if your broker pays an interest rate of 2.6%. With the Fed funds rate at 5.25%. I suspect that most brokerage firms are paying far more than 2.6%. However, even if they are, we must account for commissions. There is no cost for putting money in the money market but there are THREE commissions for the collar trade you referred to.

If your broker charged you $1 for each of the three trades, you will have effectively invested $126 to gain the 70 cents interest. If you solve the earlier equation by substituting $126 for $123, you'll find that the required interest rate is now 0.25%, or one quarter of one percent. Because most brokers would definitely charge more than $3 for the above trades, it's safe to say that you are better off in the money market.

Many new traders think that risk-free trades in the options market are a source of "free money" but you must remember that the market prices all assets according to risk. If the trade is risk-free, you're going to earn the risk-free rate. However, to accomplish this using the collar, you must pay three commissions and three bid-ask spreads and that's why the resulting interest rate is so low thus making the money market alternative more attractive.

For those who may be wondering why the collar is risk-free, it's easy to see if you break it down into the resulting rights and obligations created by the options. To create a collar, the trader purchases the shares, sells the call (has the obligation to sell shares), and purchases the put with the same strike (has the right to sell shares). In this example, if DIA is above $123 at expiration, the investor will be assigned on the short call and receive $123 cash. If DIA is below $123 at expiration, the trader will exercise the put and receive $123 cash.

No matter what happens to the price of DIA, the trader is guaranteed to receive $123 at expiration. Alternatively, the trader could place an amount of money into the money market and also be guaranteed to receive $123 at expiration. In this example, the trader receives a net credit of 70 cents for the collar so has effectively deposited $123 - 0.70 = $122.30 and will receive $123 at expiration, which is synonymous with an interest rate of 2.6%.

To ask your biggest question about options trading go here
 

Options University | 866-561-8227 | 925 South Federal Highway | Boca Raton, FL 33432