The Collar Strategy Explained

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The Collar Strategy

A collar is an options trading strategy that is constructed by holding shares of the underlying stock while simultaneously buying protective puts and selling call options against that holding. The puts and the calls are both out-of-the-money options having the same expiration month and must be equal in number of contracts.

Collar Strategy Construction
Long 100 Shares
Sell 1 OTM Call
Buy 1 OTM Put

Technically, the collar strategy is the equivalent of a out-of-the-money covered call strategy with the purchase of an additional protective put.

The collar is a good strategy to use if the options trader is writing covered calls to earn premiums but wish to protect himself from an unexpected sharp drop in the price of the underlying security.

Limited Profit Potential

The formula for calculating maximum profit is given below:

  • Max Profit = Strike Price of Short Call – Purchase Price of Underlying + Net Premium Received – Commissions Paid
  • Max Profit Achieved When Price of Underlying >= Strike Price of Short Call

Limited Risk

The formula for calculating maximum loss is given below:

  • Max Loss = Purchase Price of Underlying – Strike Price of Long Put – Net Premium Received + Commissions Paid
  • Max Loss Occurs When Price of Underlying

Breakeven Point(s)

The underlier price at which break-even is achieved for the collar strategy position can be calculated using the following formula.

  • Breakeven Point = Purchase Price of Underlying + Net Premium Paid

Example

Suppose an options trader is holding 100 shares of the stock XYZ currently trading at $48 in June. He decides to establish a collar by writing a JUL 50 covered call for $2 while simultaneously purchases a JUL 45 put for $1.

Since he pays $4800 for the 100 shares of XYZ, another $100 for the put but receives $200 for selling the call option, his total investment is $4700.

On expiration date, the stock had rallied by 5 points to $53. Since the striking price of $50 for the call option is lower than the trading price of the stock, the call is assigned and the trader sells the shares for $5000, resulting in a $300 profit ($5000 minus $4700 original investment).

However, what happens should the stock price had gone down 5 points to $43 instead? Let’s take a look.

At $43, the call writer would have had incurred a paper loss of $500 for holding the 100 shares of XYZ but because of the JUL 45 protective put, he is able to sell his shares for $4500 instead of $4300. Thus, his net loss is limited to only $200 ($4500 minus $4700 original investment).

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Had the stock price remain stable at $48 at expiration, he will still net a paper gain of $100 since he only paid a total of $4700 to acquire $4800 worth of stock.

Note: While we have covered the use of this strategy with reference to stock options, the collar strategy is equally applicable using ETF options, index options as well as options on futures.

Commissions

For ease of understanding, the calculations depicted in the above examples did not take into account commission charges as they are relatively small amounts (typically around $10 to $20) and varies across option brokerages.

However, for active traders, commissions can eat up a sizable portion of their profits in the long run. If you trade options actively, it is wise to look for a low commissions broker. Traders who trade large number of contracts in each trade should check out OptionsHouse.com as they offer a low fee of only $0.15 per contract (+$4.95 per trade).

Summary

The beauty of using a collar strategy is that you know, right from the start, the potential losses and gains on a trade. While your returns are likely to be somewhat muted in an explosive bull market due to selling the call, on the flip side, should the stock heads south, you’ll have the comfort of knowing you’re protected.

Similar Strategies

The following strategies are similar to the collar strategy in that they are also bullish strategies that have limited profit potential and limited risk.

Collar

What is a Collar?

A collar, commonly known as a hedge wrapper, is an options strategy implemented to protect against large losses, but it also limits large gains. An investor creates a collar position by purchasing an out-of-the-money put option while simultaneously writing an out-of-the-money call option. The put protects the trader in case the price of the stock drops. Writing the call produces income (which ideally should offset the cost of buying the put) and allows the trader to profit on the stock up to the strike price of the call, but not higher.

What is a Protective Collar?

Understanding the Collar

An investor should consider executing a collar if they are currently long a stock that has substantial unrealized gains. Additionally, the investor might also consider it if they are bullish on the stock over the long term, but are unsure of shorter term prospects. To protect gains against a downside move in the stock, they can implement the collar option strategy. An investor’s best case scenario is when the underlying stock price is equal to the strike price of the written call option at expiry.

The protective collar strategy involves two strategies known as a protective put and covered call. A protective put, or married put, involves being long a put option and long the underlying security. A covered call, or buy/write, involves being long the underlying security and short a call option.

The purchase of an out-of-the-money put option is what protects the trader from a potentially large downward move in the stock price while the writing (selling) of an out-of-the-money call option generates premiums that, ideally, should offset the premiums paid to buy the put.

The call and put should be the same expiry month and the same number of contracts. The purchased put should have a strike price below the current market price of the stock. The written call should have a strike price above the current market price of the stock. The trade should be set up for little or zero out-of-pocket cost if the investor selects the respective strike prices that are equidistant from the current price of the owned stock.

Since they are willing to risk sacrificing gains on the stock above the covered call’s strike price, this is not a strategy for an investor who is extremely bullish on the stock.

Key Takeaways

  • A collar, commonly known as a hedge wrapper, is an options strategy implemented to protect against large losses, but it also limits large gains.
  • The protective collar strategy involves two strategies known as a protective put and covered call.
  • An investor’s best case scenario is when the underlying stock price is equal to the strike price of the written call option at expiry.

Collar Break Even Point (BEP) and Profit Loss (P/L)

An investor’s break even point on this strategy is the net of the premiums paid and received for the put and call subtracted from or added to the purchase price of the underlying stock depending on whether there is a credit or debit. Net credit is when the premiums received are greater than the premiums paid and net debit is when the premiums paid are greater than the premiums received.

  • BEP = Underlying stock purchase price + Net debit
  • BEP = Underlying stock purchase price – Net credit

The maximum profit of a collar is equivalent to the call option’s strike price less the underlying stock’s purchase price per share. The cost of the options, whether for debit or credit, is then factored in. The maximum loss is the purchase price of the underlying stock less the put option’s strike price. The cost of the option is then factored in.

  • Maximum Profit = (Call option strike price – Net of Put / Call premiums) – Stock purchase price
  • Maximum Loss = Stock purchase price – (Put option strike price – Net of Put / Call premiums)

Collar Example

Assume an investor is long 1,000 shares of stock ABC at a price of $80 per share, and the stock is currently trading at $87 per share. The investor wants to temporarily hedge the position due to the increase in the overall market’s volatility.

The investor purchases 10 put options (one option contract is 100 shares) with a strike price of $77 and writes 10 call options with a strike price of $97.

Cost to implement collar (Buy Put @ $77 & write Call @ $87) is a net debit of $1.50 / share.

Break even point = $80 + $1.50 = $81.50 / share.

The maximum profit is $15,500, or 10 contracts x 100 shares x (($97 – $1.50) – $80). This scenario occurs if the stock prices goes to $97 or above.

Conversely, the maximum loss is $4,500, or 10 x 100 x ($80 – ($77 – $1.50)). This scenario occurs if the stock price drops to $77 or below.

The Collar Strategy

Definition:
A put option is an option contract in which the holder (buyer) has the right (but not the obligation) to sell a specified quantity of a security at a specified price (strike price) within a fixed period of time (until its expiration).

For the writer (seller) of a put option, it represents an obligation to buy the underlying security at the strike price if the option is exercised. The put option writer is paid a premium for taking on the risk associated with the obligation.

For stock options, each contract covers 100 shares.

Buying Put Options

Put buying is the simplest way to trade put options. When the options trader is bearish on particular security, he can purchase put options to profit from a slide in asset price. The price of the asset must move significantly below the strike price of the put options before the option expiration date for this strategy to be profitable.

A Simplified Example

Suppose the stock of XYZ company is trading at $40. A put option contract with a strike price of $40 expiring in a month’s time is being priced at $2. You strongly believe that XYZ stock will drop sharply in the coming weeks after their earnings report. So you paid $200 to purchase a single $40 XYZ put option covering 100 shares.

Say you were spot on and the price of XYZ stock plunges to $30 after the company reported weak earnings and lowered its earnings guidance for the next quarter. With this crash in the underlying stock price, your put buying strategy will result in a profit of $800.

Let’s take a look at how we obtain this figure.

If you were to exercise your put option after earnings, you invoke your right to sell 100 shares of XYZ stock at $40 each. Although you don’t own any share of XYZ company at this time, you can easily go to the open market to buy 100 shares at only $30 a share and sell them immediately for $40 per share. This gives you a profit of $10 per share. Since each put option contract covers 100 shares, the total amount you will receive from the exercise is $1000. As you had paid $200 to purchase this put option, your net profit for the entire trade is $800.

This strategy of trading put option is known as the long put strategy. See our long put strategy article for a more detailed explanation as well as formulae for calculating maximum profit, maximum loss and breakeven points.

Protective Puts

Investors also buy put options when they wish to protect an existing long stock position. Put options employed in this manner are also known as protective puts. Entire portfolio of stocks can also be protected using index puts.

Selling Put Options

Instead of purchasing put options, one can also sell (write) them for a profit. Put option writers, also known as sellers, sell put options with the hope that they expire worthless so that they can pocket the premiums. Selling puts, or put writing, involves more risk but can be profitable if done properly.

Covered Puts

The written put option is covered if the put option writer is also short the obligated quantity of the underlying security. The covered put writing strategy is employed when the investor is bearish on the underlying.

Naked Puts

The short put is naked if the put option writer did not short the obligated quantity of the underlying security when the put option is sold. The naked put writing strategy is used when the investor is bullish on the underlying.

For the patient investor who is bullish on a particular company for the long haul, writing naked puts can also be a great strategy to acquire stocks at a discount.

Put Spreads

A put spread is an options strategy in which equal number of put option contracts are bought and sold simultaneously on the same underlying security but with different strike prices and/or expiration dates. Put spreads limit the option trader’s maximum loss at the expense of capping his potential profit at the same time.

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