Help me understand collars?

[bltkmt]

My 95 year old mom has a $4 million investment portfolio which is great. However, one single stock position comprises just about $3 million of the total. My brother is the executor of her account and together we would like to somehow hedge the downside of that single position. I understand that option collars can do this but do not really understand how they work and what they might cost? Help please?

 

[finnski1]

My 95 year old mom has a $4 million investment portfolio which is great. However, one single stock position comprises just about $3 million of the total. My brother is the executor of her account and together we would like to somehow hedge the downside of that single position. I understand that option collars can do this but do not really understand how they work and what they might cost? Help please?

This is a definition of a collar:
"More specifically, it is created by holding an underlying stock, buying an out of the money put option, and selling an out of the money call option."
It's that simple.

However in order for protection from the down side you may well limit your upside and in either scenario you could give up possession of your stock. You will also need to keep redoing the collar over time to keep the "protection." You may be able to find a call strike and put strikes where the buying and selling of the options will be a net cost of zero or close to it such that it doesn't really cost you anything for the downside protection. You may be in love with that particular stock but personally I would not feel comfortable at all with 75% of my wealth in one stock no matter how stable it appears or what great dividends it might be providing.

 

[bltkmt]

Yes, agreed. However, it is still her account and she wants to hold it. We are just looking for protection.

 

[Sunset]

For downside protection, she only would need to buy a put.

Then she has no limit on her stock appreciation. Sure it will cost some $$ but the stock probably throws off divs anyhow.

Buying a put at a low strike price will make the put cheap, and save her from a disastrous collapse.

A big question is why she wants such a concentration of stock, just old habits or reluctance to make a change, or she inherited the stock and keeps it out of some view of loyalty

 

[ivinsfan]

So maybe I'm missing something Mom is 95 and selling this stock would most likely trigger huge taxes..if she doesn't sell kids will get stepped up basis.



I see why Mom wouldn't sell...

 

[pb4uski]

Sounds like a protective put is what OP needs but you would want to check into the tax implicons of buying and holding that protective put.

 

[bltkmt]

So maybe I'm missing something Mom is 95 and selling this stock would most likely trigger huge taxes..if she doesn't sell kids will get stepped up basis.



I see why Mom wouldn't sell...

Exactly.

 

[ctbktb]

Finnski1 definitely answered the question OP, but if you just want the protection to the downside, you buy the Put at a strike price you can live with. And remember, they are just Options. You do not need to ride them to expiration. You can sell the Put at any time and buy the next one.

Take a look at the long dated ones, out a year or two. It's not what I would call cheap insurance, but it will absolutely protect the position. If you want to mitigate the cost, sell a Call too and keep moving the Collar out as the option complex opens up.

Metoo

 

[Sunset]

Finnski1 definitely answered the question OP, but if you just want the protection to the downside, you buy the Put at a strike price you can live with. And remember, they are just Options. You do not need to ride them to expiration. You can sell the Put at any time and buy the next one.

.....

I've never done this, so I'm asking:

If one had bought a number of Puts (to protect the $3M somewhat).
The price of the stock falls really far below the Puts.
Then the person can sell the Put's for a profit, keeping the stocks and not being forced to sell them (which may still be a profit if basis is insanely low) and heirs get the step up in basis when Mom dies, (along with possible rebound in stock price).

Sound correct ?

 

[ctbktb]

Hi Sunset,

Yep, as the price decays on the underlying stock, the Puts become more valuable. In your example, the Put holder will close out the position by selling the Put and will realize a Capital Gain. Then, turn around and buy another Put at a Strike price they are comfortable with.

The above is a very rudimentary example, because there are other factors at play with Option pricing, commonly referred to as "Greeks", but simplistically, the OP just wants "insurance" in case Moms stock crashes in order to protect the gain so far. Puts provide that protection.

Metoo

 

[finnski1]

I've never done this, so I'm asking:

If one had bought a number of Puts (to protect the $3M somewhat).
The price of the stock falls really far below the Puts.
Then the person can sell the Put's for a profit, keeping the stocks and not being forced to sell them (which may still be a profit if basis is insanely low) and heirs get the step up in basis when Mom dies, (along with possible rebound in stock price).

Sound correct ?

Yep.
No one is forcing you to exercise the puts if you don't want to. As you said they would become more valuable and as long as you sold them by the expiry date you could take the profits and keep your(lower valued at the time ) stocks. You can always keep doing this and in the OP case sounds like mom doesn't want to give the m up any way.
Of course if the stock appreciates instead then you may end up with the puts expiring worthless. The puts for 18 months out can get expensive as well, could easily be 5-10% of the 3 million. Not inexpensive.

 

[Ready-4-ER-at-14]

The other people have explained collars pretty well based on my current understanding of them. I wanted to question the logic in hedging the majority of the amount.
Options have a number of factors in the pricing. One part is general interest rates which is low now. Two other parts are volatility (sort of a fear index for the market which is high) and skew which is sort or demand for puts or calls which is now high for puts). There are other factors also.
Many people only hedge a part of the portfolio, maybe as low as 25%. To do that you do fewer collars, or buy fewer puts, or you buy puts even farther down in price say at 75% of the current price and very unlikely to ever make money but are cheaper.
There are even things like spread trades using puts buying at one price and selling at another even lower.
I believe these all require level 2 trading authorization and should probably only be done with someone with options experience as there is a learning curve with everything. Perhaps your family knows all this but mentioned just in case it is new to you.
Best wishes. I am not a financial adviser just an individual with opinions on this who has some options experience but has never actually put on a collar trade as when they are cost effective I'd rather try for the actual stock gain.

 

[ctbktb]

The other people have explained collars pretty well based on my current understanding of them. I wanted to question the logic in hedging the majority of the amount.
Options have a number of factors in the pricing. One part is general interest rates which is low now. Two other parts are volatility (sort of a fear index for the market which is high) and skew which is sort or demand for puts or calls which is now high for puts). There are other factors also.
Many people only hedge a part of the portfolio, maybe as low as 25%. To do that you do fewer collars, or buy fewer puts, or you buy puts even farther down in price say at 75% of the current price and very unlikely to ever make money but are cheaper.
There are even things like spread trades using puts buying at one price and selling at another even lower.
I believe these all require level 2 trading authorization and should probably only be done with someone with options experience as there is a learning curve with everything. Perhaps your family knows all this but mentioned just in case it is new to you.
Best wishes. I am not a financial adviser just an individual with opinions on this who has some options experience but has never actually put on a collar trade as when they are cost effective I'd rather try for the actual stock gain.

+1 I think we have covered the how they work/ how the OP protects to the downside. We haven't really covered the cost portion of the post because I/we can't quantify cost without knowing the underlying position. However, the above message in quotes definitely is getting into the weeds on the dynamics at play with option pricing.

How we doin OP?

Metoo

 

[ERD50]

+1 I think we have covered the how they work/ how the OP protects to the downside. We haven't really covered the cost portion of the post because I/we can't quantify cost without knowing the underlying position. However, the above message in quotes definitely is getting into the weeds on the dynamics at play with option pricing.

How we doin OP?

Metoo

Selling puts will certainly provide some downside protection that the OP is looking for. However, when looking at this for a longer period of time (5 years or so), maybe selling most of it isn't such a bad idea? Mainly due to the costs.

Of course, at 95, we may unfortunately not be looking to a long term, but if in good health otherwise, five or six years is certainly possible ( about 30% for female, average health, non-smoker per https://www.longevityillustrator.org ).

So while paying the 15% LTCG tax (on the gains, which is probably almost all gains?) when you could see the stepped up basis sounds painful, there is that looming fear of a drop in the stock/market. And the 15% rate holds for up to $445,850 taxable for single, so she could convert much of it in 5 years @ 15%.

As mentioned, the cost of the puts must be considered (I'd avoid a collar - you have to be careful, those can be assigned to you unexpectedly, then you have the cap gains anyhow). We don't know the name of the stock, but I'll assume it's an old "Blue Chip", probably similar to P&G? Using P&G as an example:

PG is currently ~ $143/share. To protect against a ~15% drop with a 120 put would cost ~ $3.40 (well, June, so 10 months, but close enough). That's ~ 2.4% per year, so 12% spent over 5 years. And you still take the first 15% loss. Let's say PG has dropped 15% at the end of 5 years - you've actually realized a 30% drop, 15% from the stock, and 15% from the cost of puts. So you would have limited your loss to 30%, as the puts would then increase pretty much dollar-for-dollar as the stock drops. But what if you need to buy them again at the end of that year? OK, that's kind of worst case, but it might help to understand where the limit edges are.

This is where "analysis paralysis" sets in for me, and I end up doing nothing. Which is probably the best course of (in)action.

-ERD50

 

[bltkmt]

Hi all - the position is Snap On Tools (SNA).

 

[Ready-4-ER-at-14]

Wow, looking at the price from 1984 that is approaching a 20x return from 12 to 230.

Before we get too worried about cheapest way to hedge, I remember there was talk about tax plan for inheritance step up provision being eliminated in families with more than a certain amount of wealth back in may in Forbes. Is this a factor for this family if it passed? And if not a factor now, is it likely to be changed soon?

 

[ERD50]

Hi all - the position is Snap On Tools (SNA).

And approximately when was the bulk of it purchased (or what is the cost basis)? That would give a better idea of what current taxes would be due on a sale. And if none has been sold yet under average or FIFO/LIFO, and some was purchased at a significantly higher price, you could do a specific shares and lower that tax bill.

Wow, looking at the price from 1984 that is approaching a 20x return from 12 to 230.

Before we get too worried about cheapest way to hedge, I remember there was talk about tax plan for inheritance step up provision being eliminated in families with more than a certain amount of wealth back in may in Forbes. Is this a factor for this family if it passed? And if not a factor now, is it likely to be changed soon?

NOTE - Not a political statement, just a note on the effects this would have and its chances of getting passed: A quick search on this indicates that most analysis thinks this has a very tough row to hoe to become law. There is enough resistance in both parties to make passage very difficult (especially at levels that would have much/any effect on OP). It just affects too many farmers and other family businesses.

-ERD50

 

[bltkmt]

If her Morgan Stanley statement is to be trusted, cost basis is $145/share.

 

[ERD50]

If her Morgan Stanley statement is to be trusted, cost basis is $145/share.

OK, so at current price, that's an $86 gain per share, so only ~ 37% of sales is taxable gain. Keep it within the 15% bracket (depending on her income, some may be at zero), and you are paying ~ 5.5% in taxes.

I doubt you can hedge it for less than that. In the past, I've found that the best hedge is to get out of the need to hedge (except for some specific short term cases).


231−145 = 231 − 145
= 86

86/231 = 86 ∕ 231
≈ 0.37229437

.15⋅86/231 = (0.15 ⋅ 86) ∕ 231
≈ 0.055844156

-ERD50

 

[pb4uski]

An at the money put good until March 18, 2022 would cost about $20... bid $19.50, ask $20.90.... so about 8.6% for 7 months of insurance.

The capital gains tax at 15% would only be $13.... so the best way to protect your gains are to sell and pay the tax.

 

[bltkmt]

Yes, but as I mentioned she does not want to sell. I would think a collar is the most cost effective protection in that case.

 

[finnski1]

An at the money put good until March 18, 2022 would cost about $20... bid $19.50, ask $20.90.... so about 8.6% for 7 months of insurance.

The capital gains tax at 15% would only be $13.... so the best way to protect your gains are to sell and pay the tax.

I agree. That's alot of money(approx 13000 shares x $20) approx $260,000 just to save the current value. It does throw off nice dividends of $$4.92/share or about $64k a year in dividends but alot less than $260k for only 7 months of "protection".
I'd probably sell a certain percentage of it myself.
The problem is the OP's mother seems very attached to it.
I don't like to fall in love with any position I have, Much like going in to a car dealer and falling in love with a certain car. Not a good position to be in to have any bargaining power

 

[ERD50]

Yes, but as I mentioned she does not want to sell. I would think a collar is the most cost effective protection in that case.

Wait a minute - I'm not sure I understand "Exactly" what the issue is.

You say she does not want to sell. OK, but is that an emotional thing that you don't want to confront (understandable, my MIL was the same, but far less money and far better diversification).

Or, is it because she doesn't want to incur the cost of the tax hit versus the step-up (which is what you say below, with "Exactly"). I'm confused.

Originally Posted by ivinsfan View Post
So maybe I'm missing something Mom is 95 and selling this stock would most likely trigger huge taxes..if she doesn't sell kids will get stepped up basis.


I see why Mom wouldn't sell...

Exactly.

If selling is totally off the table, I think it's been shown that a put will be expensive. Yes, you can do the collar to offset the cost, but watch that closely. I've had covered calls assigned to me, and the stock sold when I didn't expect it. Going further out-of-the-money will help avoid that, but far OOM calls won't provide much offsetting income against the put.

IIRC, the call buyer can actually exercise for something like 1/2 hour after the market closes on expiry day? I've seen my stock close below the strike on expiry, and it still gets assigned because it moved up 25 cents after the close, and the call buyer could make a few pennies (or lower their loss).

-ERD50

 

[Sunset]

So Mother is happy with her good investment and doesn't want to sell.

Children eyeing the potential inheritance are worried they will get less, rather than worried about what is best for Mother. Even if investments fell to 1/2 their value, Mother would still be fine in retirement, and kids would get a large inheritance.

I don't really see a problem.

 

[pb4uski]

I can understand it... DUncle is concentrated with a lot in a single ticker that has done well for him and he is "in love" with... but it's not worth the effort to try to talk him into diversifying more because I know he'll never do it so I decided to not even try.