Jan 272014

As many of my readers are aware, I closely follow as well as invest in the offshore drilling sector.  This is a sector which has shown considerable weakness in recent weeks.  This is because the previously robust contracting activity which has served to provide tailwinds for the industry has begun to show signs of slowing down.  While most indications point to this slowdown being temporary, with the industry returning to its previous strength by the end of the year, they have not protected the stock prices of the industry’s companies from suffering marked declines.  Investors in these companies have also suffered as their portfolios suffer the reduction of value that accompanies this decline.

Historically, Seadrill (SDRL) has been one of the most volatile stocks in this sector.  This is due primarily to the company’s aggressive financial structure and dividend policy.  Perhaps understandably then, the stock has seen some substantial declines over the past few months as the stock has fallen from its high of $48.09 to today’s price of $37.61.

SDRL Chart

SDRL data by YCharts

Seadrill has certainly not been the only offshore drilling contractor whose shares have seen precipitous declines over the past several weeks.  Shares of Noble Corp. (NE) fell significantly following its earnings results and outlook and shares of Hercules Offshore (HERO) fell following news of weakening demand for rigs in the U.S. Gulf of Mexico.  However, for the purposes of this article, I will focus on Seadrill as its high dividend yield makes it an important part of the portfolios of many income-focused investors.

There are some strategies that investors can use to protect against a decline in the price of a stock.  The simplest of these is to buy a put against the stock to effectively put a floor on it because the option holder can always sell the stock to the option seller at a pre-specified price, called the strike price.  However, doing this is not cost-free to the buyer of the put option who must pay a premium to obtain this protection.  There is a way to obtain this protection at no cost though, but it does require an investor to sacrifice some of their upside potential during the period in which the downside protection is present.  That technique is known as a bear collar.

Bear Collar Defined

A bear collar is an options position in which downside protection is obtained at zero cost to the investor.  The position is initiated by purchasing a put option against a security that an investor wishes to obtain downside protection on.  This purchased is financed via the sale of a call option against the same security with the same maturity date.  This effectively puts a collar on the stock, or artificially ensures that the stock will stay within a given range from the perspective of the investor who enters into this position.  Should the stock move outside of this range then one of these options (either the put or the call) will become in the money.  When this happens, the investor with the bear collar will either be able to sell the stock at the strike price of the put option or may be forced to sell the stock at the strike price of the call option.  As a neutral to bearish strategy, the bear collar should be used when an investor fears or expects that a stock will go down prior to the option expiration date.

Seadrill is an ideal stock to put a bear collar on.  This is because the stock’s high dividend yield makes it an excellent source of cash flow but the company has encountered strong headwinds due to the weakening industry environment.  The remainder of this article will discuss how to do it via an example as I feel that this is the best way to illustrate it.

The Example

For our purposes, we will assume that a hypothetical investor owns 1,000 shares of Seadrill stock.  Furthermore, this investor expects the current weakness in the company’s stock to last for six months but does not wish to sell their shares out of a desire to continue receiving the dividend.  Therefore, this investor chooses to use a bear collar to protect this position.

The charts below from Yahoo Finance show the current prices for all of the available options on Seadrill that expire on July 19, 2014:

As the chart shows, the ask price of the $34.00 strike price put is $1.55.  This is the price that it will cost our hypothetical investor to purchase the put as the ask price is the price at which the option’s market maker is will to sell the put.  As the quoted price is the price per share but the option contract is for 100 shares, it will cost our investor $155 to purchase a single option contract and thus obtain downside protection for 100 shares.  Therefore, in order to obtain downside protection for their entire position in Seadrill, our investor purchases ten put option contracts at a price of $1,200.  This protection means that if Seadrill stock falls sufficiently so as to trade for less than $34.00 per share by July 19, our investor will still be able to sell it for $34.00 per share.

In order to pay for this protection, our investor chooses to sell call options.  As the charts above show, the $38 strike price call option has a bid price of $1.55.  This is the price that the option’s market maker is will to pay for the call option.  As with the put, the quoted call price is on a per share basis but each option contract is for 100 shares of stock.  Therefore, our investor will need to sell ten call options to cover their entire 1,000 share holding.  Upon the sale, our investor will receive $1,550, completely covering their cost of buying the put option.

By performing these transactions, our investor has effectively ensured that, from their perspective, the price of Seadrill’s stock will remain between $34.00 and $38.00 from now until July.  Should the stock trade for less than $34.00 then the investor can exercise the put and sell the stock for $34.00 per share.  Should, however, the stock trade higher than $38.00 then our investor may be forced to sell their entire holding (or whatever portion of the holding on which they obtained protection).  However, this protection was obtained at zero net cost to the investor and so the risk of possibly having to sell the shares is just the risk that the investor assumed in order to get cost-free downside protection.  For an investor that expects further downside but wishes to protect their current position though, the strategy may be worth considering.

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