REVERSE COLLARS ARE A SIMPLE STRATEGY FOR TRADING THE VOLATILITY SKEW

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The options trader can gain a tremendous advantage by knowing how to trade the volatility skew. The implied volatility of options is usually higher for strikes to the downside of stock indices and stocks. Stock markets usually crash down, not up – making the premium investors are willing to pay for disaster insurance greater. Collar strategies are simple to understand and implement for options traders of all levels..

Many traders have heard of the Long Collar, a moderately bullish option strategy. A long position in the underlying is held. Calls ares sold at a higher strike than the underlying price and puts with a lower strike are bought as protection to the underlying position.As an example, consider you were bullish on an equity index, you would purchase futures on the index, sell call options with a strike 100 points higher than the underlying price, and buy put options with a strike 100 points below the current index value. The call option premium pays for the bought put options in return for a cap on the upside profit of the position. The maximum loss is limited by the put options.

Disappointingly, the reverse volatility skew that is normal for index and share options makes put options more expensive than call options.Long collars are established at a initial cost and have a time decay cost associated with them. The underlying needs to increase for the long collar position to profit.

Consider the opposite position – a Short or Reverse Collar.The Reverse Collar involves shorting the underlying index or share, writing out of the money put options and buying out of the money calls as protection.For instance, selling short a stock at $20, selling $19 put options with 30 days to expiry for $0.18 (implied volatility of 25%) and buying protective $21 call options with identical expiry date for $0.07 (implied volatility of 15%). This position is advantageous because the implied volatility skew makes the $19 puts more expensive than the $21 calls. The breakeven of $20.11 is greater than the entry index value meaning that the position can profit even if the market goes nowhere or slightly against us. The whole structure has time decay working in our favour.

We are buying implied volatility cheap for 15% and selling high at 25%.This is exactly the sort of volatility edge we are seeking in order to maintain long term success when option trading.

The Reverse Collar trade is a neutral to bearish option strategy and has  finite upside and loss. The Reverse Collar shields the trader from being caught out in sudden short covering rallies.

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