Marek,

I could not quite get the reasoning behind the above mentioned trade. Could you please elaborate a little on how the trade works and where the "30% profit" lies.

Thanx a lot,

Jan

I could help explain the idea behind the stock collar, which involves holding a stock long, selling an out-of-the-money call option (covered call) and buying an at or near-the-money put option (protective put).  The idea is to use the call premium to finance the downside insurance (cost of the put premium). I have attached a picture to better explain the CHK trade that Marek is describing:



By looking at the graphic above you can see the possible outcomes of the CHK trade.  It shows that you are risking at maximum $100 to make up to $900.  The total requirements of this trade is $3,600 (100 shares of CHK at $34.60 + Cost of Put Option $4.80 per share - Premium from Call Option $3.40 per share).  Therefore, the investor stands to make 25% total profit from this trade if CHK is trading above $45.00 ($900 divided by $3,600), while the maximum downside risk is 2.77% ($100 divided by $3,600).  The 25% profit sounds great, but you must remember that this trade is long-term because the options contracts used expire in 2010, which is about 2.5 years from now.  If you take the 25% total profit and divide it by 2.5 years, you come out with an annualized return of 10%.  Plus, Chesapeake Energy pays an .8% dividend per year, which would add to that annualized return.

The 10% return might not sound amazing and it sure won't make you rich quick, but what you must remember is that the experts expect that the domestic equity markets will return about 7% per year over the long term.  The CHK collar trade is enticing because it is giving the investor the opportunity to participate in the growth of a great company and have the opportunity to beat the overall market return with much less risk.  Just think if you were using collars at the end of the bubble, you would have been able to preserve your capital and salvage value out of now defunct dot com companies (by exercising your protective put option).

I hope that helps explain a little behind the CHK trade that was initially described by Marek.  Feel free to ask any questions and I would be happy to help.

Bryan Moore
http://www.thefinancialwhiz.com

Logic behind this trade is: you pay insurance against down move in your stocks (buy put option), but you get premium against written call option.So at the end, ideally premiums paid and received will cancel each other and you get no downside and you have still upside up to strike price of written call option. 

You bought stocks then you bought put options (premium paid) and you sold call options (premium received). If stocks that you bought go down, you don't lose. If stocks go up you make profit from 35 up to 45. (45/35=1.285) = almost 30% .

1.You buy 100 CHK shares for 34.6$ each and immediately you buy 1 Jan 2010 put option with $35 strike (symbol is WZYMG.X).

This will protect your downside until January 2010, because you will have the right to sell each of these stocks for $35.

2. Your stocks downside is protected , (bought put option) but you have to pay premium for this insurance and this costs money.

3.To cover the costs of this insurance you sell call option with strike price $45. It means that you gave a promise to the buyer to sell him your shares for $45 for this obligation you get premium.

1.buy CHK $34.6
2.buy put option strike $35 ($4.9 premium paid)
3.sell call option strike $45 ($3.4 premium received)
 
The best thing is that if stock pays dividend then you have your premium difference (-1.5$) covered from dividend.





 

Hi Bryan,

I was thinking to make collar from synthetic call (buy stock+buy put) after the stock will rise a bit, so it could give me either higher upside potential or higher premium received - so it would cancel the difference in premiums. If I'm extremely bullish this could be slightly better choice.

There are some strategies I would like to develop:
http://www.stokblogs.com/node/679 

investing in the debt of other companies, particularly those in financial distress:
http://www.stokblogs.com/node/856

Did you consider developing any of these strategies above ?
 

Marek,

The great thing about a stock option collar is that it can be applied at any point in a trade, if you first wanted to create a protective put trade at first, you could then sell a call against the long shares to create the collar.  You could even do this with an initial covered call trade and then you close up the bottom of the trade with a purchase of a put option.

After looking at a few potential trade possibilities, I found one that follows the option collar idea, but instead of using stock, it uses deep-in-the-money call option as a surrogate long stock holding.  The idea is that a trader can now leverage the position and generate higher returns over holding the stock.  While there is an additional premium that has to be paid for the call option, if a trader is confident in a particular trade, they could leverage it using options, while maintaining some remnants of a stock option collar.

 
While your risk to reward is no longer 1 (risk) to 9 (reward), it is now about 1 to 1, but you now have increased your total return to about 45% or about 18% annualized return.  The trade would also yield $1,450 if the stock fell to $0.00, although the odds are highly unlikely that this would occur (especially if it was a company you were very confident in).

I have not developed any strategies utilizing convertible arbitrage or special situations, however, there are a limited number of mutual funds that employ these strategies in their overall portfolios.  You may want to check out my post Utilizing “Hedge Fund” Mutual Funds to Generate Consistent Returns, which is a portfolio that I definited which has consistently performed with the stock market with less than a 4% maximum downdraw in 4.5 years.  However, I have not researched individual arbitrage opportunities using convertible bonds or other financial instruments.
 

I think distressed debt investing has huge potential, although my idea of distressed debt investing differs a little from the mutual fund manager that you mentioned in your prior post.  My idea of distressed debt investing is where an investor (firm) buys debt of companies that are on the brink of bankruptcy for pennies on the dollar and then one of two things occurs:  The first is that the company completes a turnaround without filing for bankruptcy and the debt trades higher and the second is that the company enters into bankruptcy proceedings and the investor (firm) negotiates with the company to receive assets in exchange for debt forgiveness. 

For instance, if a utility company filed for bankruptcy, the investor (firm) could negotiate with the company to receive a power plant in exchange for the debt forgiveness, thus the investor (firm) would probably realize a profit from buying the debt for pennies on the dollar.

Distressed Debt type of investing is typically reserved for “accredited investors” so it is currently not possible for the small investor to play in that game.  In my school’s investment portfolio, we made an investment into Portfolio Recovery Associates (PRAA).  PRAA engages in distressed debt investing but deals mainly in unsecured consumer credit card debt.  The stock is already up over 30% since we bought it at the end of February.

Bryan Moore
http://www.thefinancialwhiz.com