There are three potential scenarios for the collar position here: We can hold it until expiration, we can walk away from the trade once our target price has been hit, or we can convert it. In the preceding example we converted the collar trade into a bull call spread. In this example we will convert the collar into a ratio spread, also known as a call backspread.
A standard definition of a ratio spread can be found on Investopedia as “an options strategy in which an investor simultaneously holds an unequal number of long and short positions. A commonly used ratio is two short options for every option purchased.” Therefore, depending on whom you talk to, by purchasing more options than you sell you are essentially in what is known as a call backspread or a ratio backspread.
The key difference is that a standard ratio spread exposes you to unlimited risk, because you have an extra short position, whereas a ratio backspread exposes you to unlimited profit potential, because you have an extra long position. Regardless of the technicality of the name, selling one option and buying two options is less risky than buying one option and selling two options. Therefore, you always want to do the former, not the latter, if your goal is to manage your risk.
Hold It
In the example found in Table 1, all of the indicators are pointing toward shorting the corn market. Placing a protective call at $5.10 protects the position from any sudden moves to the upside. The call costs $1,000. To offset the costs of the call option, a put can be sold at a point of support, $4.30. The sold put brings in $250 of premium.
Table1: Corn Classic Collar Hold
Short Futures Buy Protective Sell Put for
Call/Premium Income/Premium
Collected
Entry $5.10 $5.10 (-$1,000) $4.30 (+$250)
Exit $4.30 $4.30 (-$1,000) $4.30 (-$250)
Simply holding on to the trade until it reaches expiration results in a $1,000 deduction from the profits. The call option expires worthless, leaving $3,000 in profits. The sold put has to reach $4.25 before it can be considered profitable (determined by subtracting the strike price from the premium collected), and even if it gets that low, the short futures position can end up covering your losses. A simple profit of $3,000 can be achieved if the trade is held on to with little fanfare.
Risk
The risk for this collar is no different from the risk associated with the first example. Holding on to a collar until expiration exposes the position to multiple ups and downs in price as the market fluctuates. This occurs without the guarantee that the underlying futures position will actually ever reach the resistance level where the put was sold. Any lack of momentum on the part of the underlying futures contract will diminish the impact of the sold put. By itself the sold option cannot produce a significant source of revenue to cover the call that was bought, nor will it make up for the futures contract’s disappointing results. This leaves the trader with a maximum opportunity to gain $3,000 while at the same time leaving the trader open to making a lot less.
Walk Away
If the market is moving in the right direction but there is no desire to hold on to the trade until expiration, then the trade can be liquidated early. When we look at Table 2 we can see that the market has hit the $4.30 level, but it simply cannot break through the $4.10 level. Tremendous support has built up in the $4.30 to $4.10 range with the potential for the market to turn around and go up at any given time.
With the threat of that occurring, it may be best to exit the trade without waiting until expiration.
Table 2: Corn Classic Collar Liquidation
Short Futures Buy Protective Sell Put for
Call/Premium Income/Premium
Collected
Entry $5.10 $5.10 (-$1,000) $4.30 (+$250)
Exit $4.30 $4.30 (+$150) $4.30 (-$700)
Profit/loss +$4,000 -$850 -$450
Risk
Exiting the trade before expiration entails two additional costs associated with the trade, both of which will drag down the profits. First, by exiting the protective call you will be penalized. While you do not lose your entire call premium of $1,000, there is the potential that this can occur. In this example you end up losing $850.
The same problem arises for the sold put. The put has to be bought back at the market’s going rate. You initially collected a premium of $250, but you now have to pay $700 in order to get out of the position-making your put loss $450. This gives your corn position a total loss of $1,300 against a back drop profit of $4,000. This leaves the corn position with a net profit $2,700.
Convert It
The decision to put on a ratio spread can be difficult. There may be a feeling that the market will continue downward, but you don’t want to expose your profits to any pullbacks, nor do you want to lock yourself out of any future short profits solely because you sold a put.
That is when the ratio spread comes in. If we look at Table 3 we can see the nascent beginnings of converting from a collar to a ratio spread.
Since there is a new area of support developing around the $4.10 level, we decide to take a portion of the profits and reinvest them into purchasing two puts. The intent is get all of our short futures profits locked into our account, while at the same time avoiding taking a loss on the put that we sold.
By holding on to the short futures position until it reaches $4.10 we eke out an additional thousand dollars, bringing our futures total to $5,000. By doing this we make sure that any potential losses incurred by the put we sold are covered between $4.30 and $4.10. It also gives us a little more capital to purchase the two put options at $4.10.
One put option continues to cover the put we sold, diminish our unlimited risk, and let us get out of our futures position. The second put is our moneymaker. For $900 we get to free up the equity in our account by eliminating corn’s margin requirements, yet still participate in the drop in price and any potential chance at collecting the premium.
Table: Corn Classic Collar Convert to Ratio Backspread
Short Futures Exit Call Sell Put/Premium Buy Two Puts to Continue Short
Entry $5.10 $5.10 (-$1,000) $4.30 (+$250) $4.10 ($450/each or $900)
Exit $4.10 $4.30 (-$1,000) $3.70 (-$2,400) $3.70 ($2,000/each or $4,000)
Profit/loss +$5,000 -$1,000 -$2,150 +$3,100
In Table 3 we see the trade fully exited: no call, no puts, sold or bought. The time it takes to get to that point is almost four months. This is definitely a position trade.
Risk
There are a number of drawbacks in converting from the collar to this type of ratio spread. The first problem is the number of variables that you have to contend with leading up to the final execution of the short futures trade. If you hold on to the short futures position too long, the market has the opportunity to rebound on you and take back your profits.
A second problem arises in purchasing the additional two puts. While slightly out-of-the-money, they have the ability to be quite expensive compared to the premium you collected from the put. In fact, the expense may far outweigh the benefits of continuing the trade.
Finally, a trade that originally took only 26 days to profit now takes 103 days before you get all of your money, and the whole time you are not sure whether the trade will work. This is almost a quadrupling of your trading time frame with little guarantee that the market will continue down. If the market were to move against your two puts, you would lose the $1,100 in premium. This risk simply may not be worth it. That’s why it is important to do your math before you execute a trade like this.