So 2007 Q 2 A says their best choice is equity collar and oen of the reasons is that it preserves some upside appreciation as that is one of theri requirement. Um…how? Short Call, and Long put at the same strike…price doesnt go up or down…where is the upside there?
Equity collar was an “easy” elimination for me becasue of the lack of upside, now the evil folks at CFAI says it has upside?
remember the constructive sale rule.
If someone did an equity collar with the way you specified - they could hold on to the position - and end up looking like have sold the position and yet continue to have it on their books. This tax authorities do not like.
So for an equity collar one has to give up a little upside (15% or so) and give up a little downside (15% or so). This is done by using slightly different strike prices on the put and call (and those CANNOT equal the current stock price).
This provides a little upside and a little downside on the collar.
Eh, tricky question. I didn’t realize the answer either until I googled collars and realized that the strike price of the put won’t be equal to the strike price of the call for a zero-cost collar. I imagine the put’s strike price would be smaller than the call’s strike price, in which case if you add your initial long stock position, you end up with a payoff graph that sort of looks like a bull spread (i.e. small upside appreciation).
I could be wrong- anyone else?
Tricky, I didnt expect that to be part of it.
Thanks CP, I knew that was the case, but I didnt think US based tax law stuff would be part of this test…
I don’t the US tax law stuff has anything to do with the original question, though.
It is not US tax law - but the constructive Sale rule (enforced by Tax authorities).
I was under the impression that for a zero-cost collar, the put strike will be less than the call strike, so regardless of any constructive sale rules, the zero-cost collar will necessarily provide a little upside.
you are right. but please read the original post, and then my response to that post.
Still though, I didnt expect that wee bit of upside to be “preserving upside potential” grrr…
rolo: where you find that collar constructed by short a call and long a put at the same strike price?
What has in my mind now is that:
a zero cost collar include: long underlying + short a call + long a put inwhich call premium = put premium (the premium - not strike)
a normal collar: long a put at X1 + long underlying at X2 + short a call at X3 (X1
small correction: Collar is: Own Stock + Buy a Put + Sell a Call
thanks cpk, my vietnamese english bits me some time… especially in behavioral finance section and “essay” questions
Collar would be at price of underlying…so if ytu had a stock at 50 you’d buy put 50 and short call at 50. I don’t know where the premium falls into it, unless you wanted to structure it so that the premium netted to zero then it may not be where strike is exacly the priceof the underlying, but instead where the premiums are priced to offset each other.
Sorry, it may come from my english…but if you try to do this case, you may face some tax issue (mentioned by Cpk above)…
In general, collar constructed with buy put at X1
that why they said it preserves some upside (X3-X2)