A collar strategy is used to protect unrealized profits on stocks you already own, but it may require you to forgo some future gains.
In this strategy, you buy a protective put option to safeguard your long stock position, and you offset the cost of this put by writing a call option that is covered by the stock you own. Typically, both the long put and the short call are out-of-the-money, allowing you to protect your gains while limiting potential upside.
If the call option you write is less expensive than the put option you buy, you will pay more in premium than you receive, resulting in a debit collar.
Conversely, if the put option you buy is less expensive than the call option you write, you will receive more premium than you pay, establishing a credit collar.
TULE OF THUMB
Call and put options generally move in opposite directions. Call options typically increase in value when the underlying market price rises, while put options usually gain value when the market price falls. However, time decay and changes in volatility can also significantly impact the value of both types of options.
Is collar a protective strategy?
A collar is primarily used as a protective strategy to safeguard unrealized gains on a stock. If you have a stock that has appreciated significantly, you might use a collar to lock in those gains and protect against a potential price drop. By writing a covered call, you can offset some or all of the cost of buying a protective put. Similar to other spread strategies, a collar limits both risk and potential profit.
For example, if you bought 100 shares of XYZ at $15 two years ago and the current market price is $30, implementing a collar would involve purchasing a protective put to guard against a decline in value and writing a covered call to help cover the cost of the put. This approach allows you to secure your gains while capping potential future profits.
100 Shares
x $ 15 Per share
——————
= $ 1,500 Original cost
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In this collar strategy:
- Cost of the Put Option: $275 (or $2.75 per share)
- Premium Received for the Call Option: $250 (or $2.50 per share)
Your net cost for the collar is the cost of the put minus the premium received from the call, which is $275 – $250 = $25. This is the net amount you pay to implement the collar.
If the price of XYZ rises above $35 at expiration, your call option is likely to be exercised. You’ll sell your shares for $3,500, realizing a $2,000 profit, but you’ll forgo any additional gains beyond $35. The cost of the collar is $25, which is less than one-tenth of the cost of the protective put alone. This means you pay only $25 to secure the ability to sell your shares at a minimum profit of $10 per share, or $1,000 per contract.
A collar strategy is often most effective when you have a neutral to bearish outlook on a stock that has previously performed well, allowing you to protect unrealized gains. Some investors also use collars as income-producing strategies by selling them for a credit, though this approach requires careful management and attention.
When implementing a collar strategy, defining your range of return is crucial. This involves setting appropriate strike prices for both the protective put you buy and the call you write:
- Protective Put Strike Price: Choose a strike price high enough to secure most of your unrealized profit. This ensures you protect a significant portion of your gains if the stock price falls.
- Covered Call Strike Price: Set the strike price of the call high enough to benefit from some upward movement in the stock price. However, it should not be so far out-of-the-money that the premium received does not sufficiently offset the cost of the protective put.
By carefully selecting these strike prices, you can balance protection and potential profit while minimizing the net cost of the collar strategy.
What to do with options at expiration?
Depending on the stock’s movement, your options at expiration with a collar strategy differ:
- If the Stock Price Rises Above the Short Call Strike Price:
- If Assigned: You must sell your shares at the strike price of the call option. While you’ll secure profits over your initial purchase price, you forgo any additional gains above this strike price.
- Alternatively: You can close out your position by buying back the same call option you wrote, possibly at a higher price. This might be advantageous if the premium difference is less than the extra profit you expect from holding onto the stock or if retaining the stock aligns with your investment goals.
2. If the stock price remains between the strike prices of the call and put options:
- Put Option: You can let your put expire unexercised or sell it back, typically for less than what you initially paid due to time decay decreasing its premium.
- Call Option: Your short call will likely expire unexercised, allowing you to keep the entire premium received.
In this scenario, if your collar was a credit spread, you retain the initial credit as profit. If it was a debit spread, you will incur a loss equal to the debit.
3. If the stock price falls below the strike price of the long put:
- Put Option: You can exercise the put to sell your shares at the strike price. Your short call will likely expire unexercised, and you retain any premium received from the call.
Commissions and fees
Just like with stock transactions, options trades incur commissions and fees from your brokerage firm. These fees apply both when you open and when you close a position. Since fees can vary widely between brokerage firms, it’s important to verify the exact costs with your broker before executing any trades. Always factor these fees into your calculations of potential profit and loss.
For spread transactions involving two legs, be aware that you may incur double commissions at the time of entry. However, if a strategy results in an unexercised option, such as a covered call, and you are not assigned, you won’t need to pay additional commissions or fees upon exit.
Collar Option Strategy Explained by Inna Rosputnia
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