Collar
A Collar is a form of hedging options strategy in trading whereby an investor owns shares of the underlying stock, yet utilizes both a protective put option and a covered call option. The main purpose of such a strategy is to restrict any losses and to limit the amount of gain possible, thereby it is preferred for investors to be protected from loss due to downtrends but do not sacrifice any upside.
The Collar Setup
Assume that you have 100 shares of Company XYZ and the stock price is at $50 per share. To enter a collar:
- Buy a put option with strike price $45 (protection level) that costs $2 per share
- Sell a call option with a strike price $55 (cap on gains) that earns $2 per share
The amount received from selling the call would offset the amount paid for buying the put and this would be a costless hedge.
The collar strategy is best suited for stockholders who want to protect their investments from significant losses, especially if they are worried about short-term downside risk but are not willing to sell their shares. It is also useful for investors in a volatile market who want to maintain a long position in the stock.
By purchasing a put, you lock in the right to sell your shares at a predetermined price ($45 in this case), which limits your downside if the stock price plummets. At the same time, by selling a call, you agree to sell your shares at another predetermined price ($55), but you collect a premium that can offset the cost of the put. This trade-off caps the maximum profit you can make if the stock price rises.
The breakeven point of a collar strategy is essentially the original stock price adjusted for the net premium of the options. In this example, since the premiums offset each other, the breakeven would still be around the current stock price of $50.
The sweet spot is just below the strike price of the call option at expiration that is $55 in this example. This ensures that the stockholder maximizes capital gains from the stock yet still retains premium from the call option.
The maximum profit is capped at the difference between the call option’s strike price and the stock’s current price, minus net premiums paid or plus net premiums received. In this case, the maximum profit would be $5 per share ($55 - $50), not including the offsetting premiums.
The loss is capped at what the stock is worth minus the amount it costs to exercise the put, less any prepaid premiums. In this case, the maximum possible loss would be $5 a share, or $50 minus $45, for example, without making any adjustments for prepaid premiums.
The primary risk in a collar strategy is that of limiting potential upside. The stock’s gains are capped, which can be a significant drawback if the stock’s price skyrockets far beyond the strike price of the call option.
Time decay, or theta, generally works in favor of this strategy, particularly for the sold call. As expiration approaches, if the stock price is below the call strike price, the value of the sold call decreases, which is beneficial for the seller.
Changes in implied volatility can have a mixed impact. A decrease in volatility is generally favorable for this strategy since it reduces the value of both the long put and the short call, potentially making the options cheaper to close out if desired. However, lower volatility means less protection cost but also smaller premiums received for the calls.
The collar strategy is a good avenue for investors to hedge against large losses in bearish situations while keeping some participation in the potential gains to a certain limit. It is suitable especially for investors looking to hedge their gains with little cost pain provided they have the willingness to limit their upside potential.