Happy Friday to Barchart.com readers everywhere! TGIF.
It’s been another bad week in the markets. As I write this before Friday’s opening, the S&P 500 is down 2.2% for the week. With tensions in the Middle East at a reasonably high level and Netflix’s (NFLX) guidance missing the mark, it appears a fifth down day could be in the making.
The index remains in positive territory for 2024, up 5.7%. However, this time last year, it was up 7.8%, 210 basis points higher.
On Fridays, I usually write about three companies with unusual options activity. Still, yesterday’s options trading for Nu Holdings (NU) stuck out like a sore thumb, so I will focus on the whale of a trade that crossed the trading floor about 10 minutes before Thursday’s close.
Although I’m a neophyte regarding options, the trade struck me as a classic case of a protective collar. Here’s why.
Have an excellent weekend!
What Is a Protective Collar?
The protective collar is probably a straightforward concept for many of our readers; however, because I consider myself new to the options game despite writing about them for the past two years, I thought it made sense to at least put down on paper what a protective collar is and why people use them.
The Options Industry Council says the following about protective collars:
“An investor writes a call option and buys a put option with the same expiration as a means to hedge a long position in the underlying stock. This strategy combines two other hedging strategies: protective puts and covered call writing.”
Without getting too far into the weeds, you’ll sell one call and buy one put with the same expiration date, with both out of the money (OTM). Of course, you own 100 shares of the stock. If the share price is $10, the call strike should be higher than $10, and the put strike should be below $10.
In the next section, I’ll use the Nu Holdings example from yesterday to illustrate how and why investors do this.
The most important thing to remember is that the protective collar is established not to make a killing but rather to protect long-term gains made on the stock.
Nu Holdings’ Whale of a Trade
Nu had three unusually active options in Thursday’s trading--defined as Vol/OI ratios of 1.25 or higher and expiring after Friday——with the protective collar call and put generating a large chunk of the volume.
The neobank’s 30-day average volume is 34,335. It was nearly 8x yesterday, with the trade at 3:49 p.m. accounting for one-third of the volume.
The protective collar involved a call and put expiring on Nov. 15, 211 days from the expiration date. Both trade sizes were 40,000.
Nu Holdings share price closed yesterday’s trading at $10.66. The put was $1.66 OTM (18.4%), while the call was OTM by $3.34 (24.6%).
The 40,000 call contracts traded at $0.36 for a $14 strike. If the share price doesn’t hit $14, you keep the $1.44 million in income ($36 per 1oo shares times 40,000). That’s an annualized yield of 5.9%.
That’s not great income, but you’re trying to preserve long-term unrealized profits.
The 40,000 put contracts traded at $0.67 for a $9 strike. If the share price doesn’t hit $9, the put expires worthless, costing you $2.68 million or a downpayment of 7.4% on the four million shares at $9.
Protecting Your Nu Profits
Nu’s share price has traded below $4 twice since going public on Dec. 8, 2021. The first was in June 2022, while the second was in January 2023. If you bought your four million shares at either time for $3.50 a share, you were up 254% in March when NU stock hit an all-time high of $12.39.
In March, you were sitting on a $36 million profit. Using the June 2022 date, that’s a compound annual growth rate of nearly 106%. I can see why someone would want to protect those gains.
Assuming that NU shares hit the November expiry at $12, you get to keep the $1.44 million on the calls to offset the $2.68 million cost for the puts, bringing the net outlay to $1.24 million.
Even with the shares correcting 10% over the past month, your cumulative gain is still nearly $29 million, less the $1.24 million cost of the options for a net gain of $27.2 million over less than two years.
That’s not too shabby.
In the worst-case scenario, the shares go to $15, and you’re forced to buy another four million shares at $60 million. However, the other four million you already owned delivered $17.4 million in gains between April and November, reducing the net cost to $42.6 million.
If you like the long-term prospects for the stock, this isn’t the worst tradeoff in the world. You’d be sitting on an average cost per share of $9.25 a share [$3.50 per share times four million plus $60 million divided by eight million shares].
What’s not to like?
On the date of publication, Will Ashworth did not have (either directly or indirectly) positions in any of the securities mentioned in this article. All information and data in this article is solely for informational purposes. For more information please view the Barchart Disclosure Policy here.
