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This week's question:

DATE: September 29, 2008

QUESTION:
How do I protect my holdings in Frontline (FRO) against the risk in price, and volatility with a protective collar or other option strategy? This a high dividend stock that needs to be protected.

ANSWER:
A protective collar is created by purchasing a put option and selling a call option with a higher strike price.Typically, the strike price of the put is below the current stock price and the strike price of the call is above the current stock price.For example, with a stock price of $64, the 60-strike put might be purchased and the 70-strike call might be sold.The goal of selling the call is to collect some option premium that can be used to reduce the cost of the put.

While the collar is a popular strategy for protection, stocks with "big dividends" present some unique challenges.In the case of FRO, for example, the 60-strike put expiring in September 08 currently costs about 3.90, and the 70-strike call expiring in the same month can be sold for approximately 2.20.This means that the cost of this collar is about 1.70 per share for the next seven weeks, which spans the next dividend date in early September.Note that the cost of approximately 1.70 is very close to the amount of the dividend.

If you look at a later expiration, such as February 2009, then the cost of protection increases dramatically.The 60-strike put expiring next February costs approximately 10.00, and the 70-strike call expiring next February can be sold for approximately 3.60.Therefore, the cost of this collar through next February is about 6.50 per share or about 90 cents per share per month.This exceeds the amount of the dividend.If the investment goal is to collect the dividends for income, then these examples of using collars for stock price protection defeats the goal of getting income.

Typically, the collar is used when the stock price forecast is bearish but the investor does not want to sell the stock for tax reasons.Alternatively, a collar can be used when establishing a new position in a stock.In this case the collar limits risk and allows some potential for stock price appreciation.