A collar is an options strategy that consists of buying or owning the stock, and then buying a put option at strike price A, and selling a call option at strike price B. An options trader who enters this strategy wants the stock to trade higher and get called away at the call strike price B. However, also wants protection in case the stock price falls below strike price A, giving the them the right to exercise the option contract and sell the stock if it does.
A collar option is essentially what would happen if a trader wants to run a covered call and a protective put at the same time. This strategy is usually executed when the investor wants downside protection but does not want to pay for it. So to cover their cost, they limit their upside potential in exchange for capping their downside exposure. This strategy may be applied to both short-term and long-term positions.
When to Use a Collar
An investor should consider using a collar if they are bullish on the stock for the long run, but are concerned about short-term downward movement. Such things might include uncertainty about earnings, a world health pandemic, or any other short-term market uncertainty.
An investor may also use a collar when they have significant gains in stock that they wish not to risk. Here an investor can implement a collar option strategy to protect the profits they have already generated.
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To implement the collar, the investor purchases an out of the money put option, which protects against a price drop in the stock. They then offset the premium paid for this put option by selling an out of the money call option, expiring in the same month against it.
The collar is a highly useful strategy in a volatile market, it protects the investor for little to no cost, giving them the ability to limit their potential loss if the stock trades down, in exchange for limiting their potential profit. Because the call option is sold above the stock price, there is still room for the investor to profit, while at the same time, easing their concern with the stock trading down.
The maximum profit is calculated by taking the difference between the stock price and the short call, then subtracting the cost of the collar if acquired with a debt or adding the premium received if the position was opened for a credit. For example, if the stock was trading $100 and the investor acquired a 95/105 the collar for a $0.30 credit, then the max profit would be $5.30.
The maximum loss is calculated by taking the difference between the stock price and the long put, then adding the cost of the collar if acquired for a debt, or subtracting the premium received if opened for a credit. For example, if the stock was trading $100 and the investor acquired a 95/105 the collar for a $0.30 credit, then the max loss would be $4.70.
The collar option has a single breakeven point but is calculated differently depending on if the collar was acquired for a credit or a debit.
If the collar is acquired for a credit, the breakeven would be calculated by subtracting the premium received from the stock price.
If the collar is acquired for a debit, the breakeven would be calculated by adding the amount paid to the stock price.
If XYZ is trading $100 and is expected to trade lower over the next three months, a trader could execute a 95/105 collar by buying the stock, buying one 95-strike price put, and selling one 105-strike price call for the following prices:
- Buying 100 shares of XYZ stock at $100
- Buy 1 XYZ 95-strike price put for $1.50
- Selling 1 XYZ 105-strike price call for $1.80
- Total premium = $0.30 credit
If the stock trades up to $107 at expiration, the call will get exercised and the investor will be forced to sell the XYZ stock in their inventory at the price of $105. This means they will make $5.00 on the stock, but because they also received a $0.30 credit, they will have a net gain of $5.30.
If the stock trades down to $91 at expiration, then the trader will exercise the 95-strike price put, selling the stock at $95. This would mean they took a $5.00 loss on the stock, but because they sold this collar for a credit of $0.30, their net loss would be $4.70. Although losses are never good, it this would be a far better situation than if they didn’t have the collar on and had to absorb the whole $9.00 loss.
There is only one reason to enter a collar, to allow the possibility of upside potential while at the same time limiting downside risk. This type of option strategy can be acquired simultaneously with the stock or added to an already existing stock position. One of the best things about the collar option strategy is that the trader knows, right when they enter the collar, the maximum gains and losses on the trade. Here the trader gives up the potential for huge gains in exchange for limiting their losses.
It has very little sensitivity to changes in implied volatility as it is short one option and long another balancing out the volatility effect.
The collar is an excellent strategy for a beginner as it allows for a trader to capitalize on the upside, while keeping the trader relatively safe if they turn out to be wrong about their bullish projection.