What Is a Collar?
A collar, often referred to as a hedge wrapper or risk-reversal, is a strategic approach in options trading designed to shield your investments from substantial losses while capping your potential profits. It’s particularly useful if you remain optimistic about the long-term prospects of a stock you own but remain cautious about market volatility in the short term.
To initiate a collar, investors buying an out-of-the-money put option builds a safety net if the stock price decreases. Concurrently, they sell an out-of-the-money call option above the current price, bringing in income that can offset the costs associated with acquiring the put option. This method allows the investor to gain from the asset up to a specified cap—the call option’s strike price. While this technique offers substantial protection against significant declines, it naturally limits potential upside.
Key Takeaways
- A collar strategy involves purchasing a downside put option and selling an upper call option to mitigate large losses and limit large gains.
- Combines methods such as protective puts and covered calls to ensure a balanced risk-to-reward ratio.
- The ideal outcome is achieved when the underlying stock’s price matches the strike price of the sold call option as it expires.
Understanding a Collar
Investors typically utilize collars on stock whose value exceeds its purchase price, harboring optimism for further gains yet seeking a hedge against near-term uncertainty. By creating a collar, one can harness both protective and lucrative elements tailored to diverse market conditions.
Implementing a Collar:
- Buying a Put Option: This is akin to buying insurance for your asset. It assures a predetermined sell price, thus shielding against substantial losses should the market take a downturn.
- Selling a Call Option: Involves an agreement to sell your stock at a defined price down the road, generating immediate premium income that can offset the put’s purchase costs.
Prerequisites:
- Align the expiration month for both put and call options, ensuring equal quantities to maintain balance.
- Ensure the put option strike price is below the current stock price, while the call option strike price is above it.
- Aim for income from the call sale to adequately cover the put purchase cost, minimizing additional financial outlay.
This configuration caters to those averse to extra expenditures while maintaining contentment amidst capped potential gains.
Break-Even Point and Profit or Loss Calculation
With a collar, the break-even point comes when the net value of options costs is neutralized by gains or losses, laying the groundwork for ultimate financial equilibrium:
- Break-Even (Debit):
Stock Purchase Price + Net Premium Paid - Break-Even (Credit):
Stock Purchase Price - Net Premium Collected
Calculations:
- Maximum Profit (Debit):
Call Strike - Stock Purchase Price - Net Premium Paid - Maximum Profit (Credit):
Call Strike - Stock Purchase Price + Net Premium Collected - Maximum Loss (Debit):
Put Strike - Stock Purchase Price - Net Premium Paid - Maximum Loss (Credit):
Put Strike - Stock Purchase Price + Net Premium Collected
Protective Collar Example
Suppose you own 100 shares of ABC stock, bought at $80 per share, presently valued at $87. Fearing market fluctuations, you decide to temporarily hedge the position:
- Buy One Put Option: Strike Price of $77, Premium of $3.00.
- Sell One Call Option: Strike Price of $97, Premium of $4.50.
Cost or Credit to Set Up the Collar:
- Net Credit: $1.50 per share, or $1,500 in total, as the call option sale yields more than the put option purchase.
Breakeven Point Calculation:
Breakeven = Underlying Cost + Put Cost - Call Premium Received = $80 + 3 - 4.5 = $78.50
Maximum Profit Calculation:
Maximum Profit (Credit) = Call Strike - Stock Purchase Price + Net Premium Received = 97 - 80 + 1.5 = $18.50 per share or $1,850
Maximum Loss Calculation:
Maximum Loss (Credit) = Put Strike - Stock Purchase Price + Net Premium Received = 77 - 80 + 1.5 = -$1.50 per share or -$150
Pros and Cons of a Collar Strategy
This strategy caters to those seeking stability amid market uncertainty, provided they accept the inherent trade-offs:
Pros:
- Downside Protection: Minimizes risk of substantial losses.
- Marginal Upside Participation: Retains potential for some gains.
- Cost-Effective: May result in net credit.
Cons:
- Limited Upside: Caps profit potential.
- Active Management: Requires diligent monitoring.
- Higher Cost: More expensive compared to covered calls.
Why Is It Called a Collar?
Named aptly, the collar strategy ‘collars’ stock value within bounds, resembling a neck encirclement. It secures a protective floor and a growth ceiling, providing a structured approach to investment safety.
Best Time for a Protective Collar
Ideal for those bullish in the long run, but wary of near-term volatility, particularly if they’re nearing a crucial financial milestone or needing to safeguard against impending market corrections. Best utilized under high market volatility.
How Does a Collar Protect Against Losses?
By setting a defensive floor (put option) below the stock’s value, and a growth ceiling (call option) above it, potential losses are capped relative to the ensured puts pricing. The strategy strikes a balance, mitigating risk at a known cost.
Modifying a Collar Strategy Before Expiry
Adjustable prior to options expiry, offers flexibility according to evolving market perspectives, but at a potential financial cost. Regular assessment and tactical agility are crucial, especially in volatile markets.
The Bottom Line
The collar stands as a strategic defense, curbing downside risks while tempering upward gains. Embracing aspects of protective puts and covered calls, it’s prime for those moderately bullish but wary of near-term dips. By ‘collaring’ stock value, it informs cautious optimism, balancing risk and reward.
Related Terms: protective put, covered call, risk reversal, hedging strategy.
References
- E. Sinclair. “Positional Option Trading: An Advanced Guide.” John Wiley & Sons, 2020. Pages 138-142.
