Marek over at Stokblogs.com wrote a post about a trade involving Chesapeake Energy (CHK). He looked into utilizing a stock option collar on the position, which from my previous post, “Option Collars - Low-Risk, Low-Cost, Market Perform Trading Strategy.” can be explained as 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). Below are some graphics with a more detailed breakdown of the CHK trade that Marek described in his post:
The graphic above illustrates the possible outcomes of the CHK trade. It shows that the investor is risking, at maximum, $100 to make up to $900. The total requirement 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 the investor must remember that this trade is long-term because the options contracts used expire in 2010, which is about 2.5 years from now. Taking the 25% total profit and divide it by 2.5 years shows an annualized return of 10%. Furthermore, 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 a person rich quickly, but 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 gives the investor the opportunity to participate in the growth of a great company as well as the opportunity to beat the overall market return with much less risk. Just think if an investor used collars at the end of the bubble; he would have been able to preserve his capital and salvage value of now defunct dot com companies (by exercising the protective put option).
Please note: This analysis does not take into account taxes and commission. This is meant for illustrative purposes and is not meant to be used as professional investment advice.
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