Whenever owners of concentrated stock positions have obtained their shares at a cost well below the stock’s current fair market value, an equity collar may be the answer. Although the gain has yet to be realized, many shareholders wish to preserve the value of the shares without entering into a taxable liquidating transaction.
To secure share value, the owner could simply purchase protective put options, but put premiums make this an expensive proposition.
What It Is
An equity collar is a hedging technique designed to protect a stock from downside price risk at little to no out-of-pocket cost to the shareholder.
Here’s how it works: The shareholder purchases protective put options on the shares s/he owns while simultaneously selling covered call options on those same shares. The protective put places a price “floor” on the shares, while the call creates an upward “ceiling.”
The options are typically purchased and sold so that the strike price is “out of the money” in relation to the current price of the collared shares. The sale of the call option contracts results in the collection of a premium, which is then used to offset the premium costs associated with the purchase of the put options. Thus, these hedging transactions are often referred to as “zero-premium” or “cashless” collars.
For example: Mr. Stevens owns a large, highly appreciated position in CBA Inc. It is June, the end of CBA’s quarter, and Stevens is concerned that there may be short-term pressure on the share price; on the other hand, he believes that CBA’s long-term prospects remain very strong. Because he’d realize a large taxable gain if he sold them. Stevens would like to structure a zero-premium collar for his CBA shares, which currently trade at $50 per share, for the next three months.
CBA September $55 call contracts trade at $2 each, and CBA September $45 put contracts also trade at $2 each. Stevens sells the calls and receives a $2 premium per contract, while simultaneously purchasing the puts at $2 per contract. The premiums he receives for the calls offset the cost of the protective puts, resulting in a no-cost hedge.
During the term of the collar, $45 represents the protective floor at which Stevens can sell his stock regardless of how low the price drops; $55 represents the ceiling up to which Stevens may participate in appreciation of the shares. If the stock trades above $55, the shares may be called away regardless of how high the actual price is.
Points to Consider
As a protective hedge, an equity collar is best suited for shareholders with significant gains in their shares who feel that, while the price of the stock may be neutral or slightly bearish in the short term, the stock’s long-term outlook remains bullish. Many shareholders also use collared shares as collateral to obtain loans, as lending institutions are more likely to lend larger amounts against protected assets.
An equity collar can be very effective in protecting the value of a concentrated position, but it must be structured properly to achieve a zero-cost outcome and to avoid unintended tax results.
Gary S. Williams, CFP, CRPC, AIF, is president and founder of Williams Asset Management in Columbia. He can be reached at 410-740-0220 or at firstname.lastname@example.org.