One way to soften the blow, grab them by a collar

Financial Review

There is a range of strategies available to traders of shares via derivatives depending on the view a trader has about the shares over a particular time horizon like a post company reporting season and the payment of dividends.

Consider BHP Billiton shares, which have drifted lately in the wake of the company’s demerger proposal.

With the shares due to trade ex-dividend on Wednesday, the last opportunity traders have to buy them with the fully franked 66.4¢ dividend – a strategy for those who believe the 7 per cent decline in the share price from above $39 since the demerger news has been overdone – is an options strategy described as a collar.

A collar, says Ord Minnett options specialist and senior derivative adviser Wai-Yee Chen, is a strategy where traders can use an exchange traded options combination to trade a view that BHP shares could do better over the next couple of months than the $36.70 and slightly below the region they were trading at on Monday.

At the same time the strategy can provide protection against a sharp fall in the share price, post the dividend announcement.

When shares trade ex-dividend it is quite common for them to give up the dividend amount and possibly be vulnerable to further falls.

With a collar strategy, a share decline is protected through the purchase of an exchange traded put option, in this instance a $35 October expiry put option.

For a trader willing to buy BHP shares around the $36.70 level, for the dividend plus any possible capital profit, says Chen, a risk the shares will slump beyond the dividend payment can be managed with the use of options.

If a trader is willing to cap the next two months’ upside to 5 per cent (including the dividend) while being able to tolerate a maximum of 5 per cent downside, then the purchase of shares can be hedged or protected by paying for a 23.5¢ per share collar.

This involves buying a October expiry out-of-the-money $35 put option for about 51¢ and partly funding this by selling a $38.01 call option and receiving 27.5¢ for this plus the dividend and any potential capital gain in the next two months.

A thing to note about the strategy is that rather than a big profits play, a collar is considered a risk management strategy that can suit an uncertain market. In a more bullish market environment, it’s actually a reward limiting strategy.

By selling a call, investors run the risk that if the shares rally strongly they will almost certainly be called away at the call option exercise.