Profit From the Extreme Volatility Using Collar Options

day_trader's picture
October 12, 2008 by day_trader

With the extreme volatility in the markets over the past few weeks, I wanted to start positioning myself into some longer term value plays with the lowest amount of risk possible.  Risk management is the name of the game right now and I want to set up the best reward:risk ratio on my trades. 

The hedge fund liquidation or deleveraging that we saw has destroyed many of the commodity plays; silver, gold, and oil stocks have been massacred.  There are many fundamentally sound companies with solid balance sheets that have lost 80% of their value over the past 3 months.  The odds of many of these companies moving to 0 is very small.

By utilizing collar options, you can setup a very high reward to risk ratio in the area of 4:1 to 8:1 if you can find the right situation.  For those of you who are not familiar with collars, you are basically going long the stock, long the LEAP put option at a strike closest to the purchase price of the underlying, and short the LEAP call option which is deep out of the money.  You are essentially creating a small debit spread which will be the bulk of the risk in the trade.

Let's take a look at the featured setup that I am seeing as a great value.  There are many out there but I really like this one.  PAAS has been hit over 70% off its highs set last year.  I expect gold to find a bottom shortly but I am not concerned with the exact timing as this setup allows me to take extremely small risk.  Here is the play: 

Long PAAS at 13.50s area
Long PAAS Jan 2010 15 Strike Puts at around $6
Short PAAS Jan 2010 25 Strike Calls at around $3

PAAS LEAP Put Option Chain
  PAAS Leap Call Option Chain

So with this setup, we are looking at a net options debit at around $3 and, of course the cost of going long the stock itself at around 13.50.  Therefore; your downside risk is a maximum of 13.50 - (15 - 3) = $1.50.  Risk in this trade is about 10% of your capital, even if PAAS runs to 0.

The upside potential is staggering, if PAAS breaks above $25 by Jan 2010, you will make $25 - $13.50 - $3 = $8.5.  Considering that you paid 13.50 for the stock, this is almost a 63% return on investment.  Your reward to risk ratio is almost 6:1.

If PAAS does not move much by Jan 2010, you would need the stock to be above $16.5 to break even.  Not a bad looking trade.