Short Sale - Long Collar: the Perfect Hedge

This may be the perfect hedge: Short Sell a weak stock and then use a long collar to protect against it going higher.  I have been experimenting with this strategy and it is so far working very well. 

 

Here is how it has gone: on January 15 I sold short 300 shares of Radioshack (RSH) at 14.17.  RSH has shown weakness for over a year, though it did have a good spike the middle of 2007.  But lately, it has done poorly along with the rest of specialty retail.  Because the risk on a short sale is unlimited to the upside, I wanted to provide protection, so I bought (3) Feb $15 Call contracts for $0.75 each (each contract covering 100 shares).  To help pay for the Calls I sold (3) Feb $12.50 Put contracts for $0.40.  This left me some room to the downside to profit from continued weakness in RSH (14.17 - 12.50).  If the price of the stock continued to drop below the strike price of the sold put, I would realize a profit of $1.67 + 0.40 - 0.75 = $1.32 per contract (or $396 for all 3) when the put was assigned, taking out the short.  Over the one month time frame, this would provide an annualized gain of over 100% (using only margin, as shorts and sold puts require no capital).

 

But what would happen if the price of RSH rose in the meantime?  I just found out and am pleasantly surprised.  The fear of all short sellers is a rising stock price.  But using the collar, I guaranteed upside protection with the Call contracts.  I sold those contracts yesterday as the price of RSH had risen to $16.80 at the time of the sale.  Here is how the math has worked out on this transaction:  Call price on 15 Feb strike rose to $2  on Feb. 1, 2008 (it was at $2.70 earlier in the day but I have job and wasn't monitoring the contract price).  I closed out the Call contract for $2 and also closed out the short Put contract at $0.05.  My total gain on the Put and Call option contracts was (0.40 - 0.05 + 2.0 - 0.75) $1.60.  In effect, this raised the basis on my short to 14.17 + 1.60 = 15.77.  

 

I turned around and did another collar, though quite a bit higher, with a March expiry sold Put with 17.50 strike for $1.53 and a collaring $20 Call for a paid premium of 0.68.  The worse case scenario is a close below 17.50 on March 22 in which case the put option would be assigned and the Call would expire worthless.  In this case, the total possible loss is $17.50 - 1.53 + .68 = 16.65 - 15.77 (new basis) = 0.88 a share, about the same risk as for the Feb contract, so effectively rolling the strategy forward even in a market with rising prices.  But if it closes above 17.50, the sold put premium will be booked and will again increase the basis on the short position. 

 

Bottom line: this is a reasonable way to put in shorts against weak stocks while mitigating risk.  The weakness of this strategy is limited profits on a dropping stock price.  But it will do very well with flatish prices (renewing the collar will generate profits each month) and will provide protection with rising prices.  It might be possible with this short strategy even to profit with rising prices with good timing (which was not the case here as I gave up 0.70 in profit with bad execution on Friday). 

 

I will keep you posted to performance future months, and may add a couple more candidates, like Washington Mutual (WM), Garmin (GRMN) or CROX.