A collar is an options strategy that consists of buying or owning the stock, and then buying one put at strike price A, and selling a call at strike price B. An investor 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 them the right to 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.
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 collar 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 the collar 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 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 losses on the downside. A collar option can be acquired simultaneously with the stock or added to an already existing stock position.
This type of trade 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.