Rising Rates: How Option Collars Can Now Lock Even More Gains

As call options get more expensive than puts, a traditional option collar strategy can lock in more gains on stocks you own.

Sometimes the obvious sneaks up at you ­­- even when it’s so clear in hindsight. But I was oblivious to the obvious – until last week.

Earlier this month, I attended the most recent Tastylive “Bad Trader Tour” event. This was a chance to meet some of the Tastylive hosts and talk about options, probability, trading, and investment strategies.

During Nick Battista’s presentation – which covered several topics – he briefly showed how rising interest rates affected at-the-money (ATM) options.

As the Fed has hiked interest rates, ATM calls on ETFs such as SPY now trade at more of a premium to the ATM puts. So he showed an example of how setting up an option collar can lock in higher gains.

I’ll explain how a collar works and why rates affect option pricing, but first take a look at interest rates for one-year T-bills going back to the 1970s:

As I mentioned, it now seems so obvious. I knew interest rates make a difference in how ATM calls are priced relative to puts. And I knew how that might affect option collars.

But I’ll go easy on myself because as you can see, rates haven’t been this high since 2007. Some investors may not have ever traded options with rates so high.

The option collar: Selling calls to buy puts

What’s a collar? This is a trade that includes buying or owning stock, then buying an ATM put and selling an ATM call at the same strike price.

You give up any gains on the stock, but you also hedge against losses. The higher the prevailing interest rate, the more money you collect for the call you sell and the less you pay for a put option.

This isn’t the exact example Nick showed, but it’s similar. I looked at option prices on the SPY ETF at the close on August 15. With SPY at about 442.90, you could have:

• Bought 100 shares of SPY for $44,290
• Bought 1 September 2024 ATM put for $2,490
• Sold 1 September 2024 ATM call for $4,332

(Note: To show this example as right at-the-money, I weighted the average of the 440 and 445 strikes for both calls and puts.)

Result? You net a $1,842 credit for the two options to reduce your cost of the stock to a debit of $42,448. And over the course of the year, you’ll collect dividends to bring your total cost down to about $41,629.

Getting hotter under the collar: Even more gains?

What happens with a collar? Nothing if you just sit on it. At expiration, it’s guaranteed to be worth what you paid for the stock – $44,290. Your short call means you won’t benefit from gains in SPY, but your put protects you from losses, as this diagram shows:

So with this collar you net $2,661 at expiration (including dividends) on your initial debit of $42,448, or 6.27%, regardless of where SPY is trading.

Nick pointed out that he selected an option series with more than a year to expiration because long-term gains may be taxed less than short-term gains.

(This is a good spot for my obligatory “consult your tax advisor” disclaimer about taxation, and to note that there is some risk that your call option could be exercised prior to expiration.)

Does 6.27% seem like a decent return? That depends on your outlook for the stock market and interest rates. There may be bonds you can buy that yield more.

As for me, I don’t think the potential gain is worth the capital required, but it may be a good tactic for stock you already own. Or you could collar some of your shares, leaving the rest to perform along with the market.

But a collar doesn’t need to be static. Sometimes it’s possible to adjust your position to collar even more gains.

Let’s say SPY moves up. It may not be possible to roll your collar up to higher strike prices without paying a debit. Nothing is certain, but implied volatility is usually not as high ­when a stock rises.

On a move down? That may be a different story: Let’s assume that after about 90 days, SPY falls about 10%. On August 15, option prices showed that if you had already established a position like this 90 days ago and SPY was now 45 points lower, you could have:

• Bought back your now out-of-the-money call for $1,190
• Sold your now in-the-money put for $4,400
• Sold a now at-the-money call (45 points lower) with the same expiration for $3,660
• Bought the same strike put for $2,123

You’d net an extra $4,748 credit. Your existing stock position would be “collared” at $4,500 less than when your first set it up, but the difference of $248 boosts your overall gain from $2,661 to $2,909 – or 6.85% of your initial debit.

Depending on how the market behaves, you may have several opportunities to reduce your basis in this position and lock in more gains as the year goes by.

The impact of interest rates on ATM calls and puts

As I mentioned, if you have traded options for less than 16 years, you may never have noticed how a collar like this can change in value based on interest rate changes.

But why do interest rates impact option pricing?

The reason that the prevailing interest rate is a variable in the Black-Sholes option pricing model is that if you buy a call instead of buying stock, the cash you save can earn more interest. And buying a put option isn’t as attractive because you can earn more interest by shorting the stock.

That’s a short simplistic answer, of course. There are other variables that go into the pricing model, but I used the Black-Sholes model to plug in various interest rates for an ATM SPY collar that expires in one year based on current implied volatility levels. This chart shows the P&L and ROI for such a collar:

This is theoretical, of course, but shows the relationship between interest rates and prices of these collars.

Finally, this chart uses actual option prices as of August 15 to show how much the value of this same ATM collar on SPY increases for longer-dated options:

As I mentioned, this isn’t necessarily a trade I’d set up on a new stock, but I’d certainly consider it for stocks I own that have enough option liquidity to make this strategy worthwhile.

And again, yes, I knew rates were going up, but it kind of snuck up on me that ATM collar pricing was also rising. So thanks again to Nick Battista for reminding me!