There are two final strategies that options investors should be aware of: collars and butterflies. Although these two are not as widely used as the other strategies we've detailed previously (please see lessons #1-5 for details), they can often prove very useful when the situation is right.

Collar
A collar is an interesting strategy that is often employed by major investment banks and corporate executives. This position is made by selling a call option at one strike price and using the proceeds to purchase a put option at a lower price. The cost to the investor to make this trade, therefore, is essentially zero.

Investors who hold a large position in an underlying stock and wish to liquidate their holdings at some time in the future commonly use this type of trade. Why? Well, the collar allows them to lock in a particular sale price (in actuality, it ends up being a range between two prices) ahead of time. In other words, after implementing the collar trade, they then know the exact highest and lowest dollar amounts they could potentially receive when they sell their underlying stock. Speculators do not commonly make this type of trade since it is a high-risk, low-reward scenario unless you hold the underlying stock. However, if the investor already owns the underlying stock, then the trade is very low-risk and low-cost.

Example:
Judy is an executive at IBM and has recently been awarded a significant amount of IBM stock, which is currently trading at $100. She feels strongly about IBM’s prospects over the next three months, but she remembers that many other people who worked at high-tech firms had the same belief in the 1990s when the Internet bubble collapsed. Most of these people lost virtually all of their investment. In this particular case, however, Judy cannot afford to lose her entire investment. On the other hand, she would also like to try to get $10 more for per share her stock, or $110.

After assessing her personal financial situation, Judy determines that she cannot afford to sell her shares for anything less than $90. To hedge her current holdings, she decides to institute a collar trade. (This trade gets its name because the position is essentially "collared" between two prices.) It is currently January, and to collar this position for three months she sells one IBM MAR 120 call for every 100 shares she owns. With the amount she receives from this sale she simultaneously buys one IBM MAR 80 put for every 100 shares that she owns (we will assume that both sides cost $5 each). Since both of these options cost the same price, the net cost of this initial trade was $0 to her. With this trade, Judy now knows that no matter what happens, she will receive an amount between $90 and $110 if she decides to sell her IBM shares when the options expire in March.

As the graph above illustrates, Judy's total profit or loss from the combinations of these positions is limited to $10. This means that if IBM rockets up to $200, the most Judy will receive is $110. Conversely, if IBM crashes to $20, the least she will receive is $90. For an investor who is comfortable with either of the two scenarios, this is an excellent hedging strategy.

Butterfly
Traders often use the butterfly strategy when they feel a particular stock will remain neutral during a certain period. By entering into a butterfly trade, the trader is essentially betting that the underlying stock price will remain close to where it is currently. This trade requires three separate positions (four total contracts), and is therefore a bit more complex than the collar. It can be made using either put options or call options. For simplicity, we will use calls in this example. To execute this trade, the investor will need to buy two calls -- one at a low strike price and one at a higher strike price. The investor also needs to sell two options with strike prices at or near the current price. In the end, this type of trade will pay the maximum amount if the stock finishes at the middle strike price. The trade has very limited downside risk, but the trader must estimate the correct future stock price to a fairly narrow range in order to make the trade profitable.

Example:
An investor believes that IBM, which is once again trading at $100, will remain relatively unchanged during the next month. To take advantage of this, but also desiring to limit downside risk, the trader sets up a butterfly trade. To do this, the trader buys one IBM 95 call for $6 and one IBM 105 call for $1. The trader will also sell two IBM 100 calls for $3 each. The net result of all of these positions will be a cost of just $1 to the trader, as shown below:

A butterfly trade may seem complicated at first glance due to the large number of options positions required to construct it. However, a quick look at the diagram above should make the payoff relatively easy to understand. In this example, the trader obtains the maximum payoff when the stock finishes at $100. As IBM's price moves further and further from $100 in either direction, the trade begins to lose value. When the price reaches (or moves beyond) $95 or $105, the trade then leads to a maximum loss of $1. This diagram clearly shows just how accurate the trader must be at forecasting IBM's future stock price in order to reap a profit from the trade. If the outcome does not go according to plan, however, then the worst that can happen is the trader loses $1, no matter how high or low the price goes.

Conclusion
The two options strategies outlined above -- the collar and the butterfly -- should only be used in very specific situations. However, when used effectively, they can be extremely profitable. A collar can help lower your volatility during an uncertain time period and can help you lock in a range of sale prices for a stock you currently own. Meanwhile, the butterfly is a good strategy for periods where a stock is not likely to fluctuate to a great degree. The butterfly trade can change what would normally be an unprofitable trading period for the stock into a profitable one.

Please visit the link below to view our final options trading lesson.  In it, we'll introduce you to the two most important components of an option's value--intrinsic value and time value.

-- Jeff Bishop
Staff Writer
StreetAuthority.com

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