Many investors have been in a situation where they wish to lock in profits while keeping their existing upside potential. For example, employees who have most of their 401(k)s invested in company stock may want to hedge against any sudden downturn in the company, while investors lucky enough to have struck gold with a solid stock may want to reduce some of their risk and lock in profits. Traditionally, this has been done by purchasing put options. The problem is that this strategy costs money. This article will cover how to lock in profits using a different and more economical strategy - collars.

Collar Basics
A collar is a stock option strategy in which an investor purchases a put while simultaneously writing a call against the stock position. The most common collars are constructed by purchasing one put and writing one call for every 100 shares of underlying stock that you own. The put provides downside protection, while writing the call finances the purchase. The end result is a "free" way to lock in profits in which the only downside is the fact that your upside is limited. After all, the written calls will force the investor to sell his or her underlying stock position if the stock price rises above a given price before expiration.

Here's what the option's profile looks like:

Created Using CBOE Option Toolbox
Figure 1

Here are the key calculations for this strategy:

  • Maximum Risk = Cost of Put - Credit from Call
  • Maximum Profit = Differences in Strike Prices - Net Debit Paid
  • Breakeven Point = Current Stock Price + Net Debit Paid

Using these calculations, you should be able to quickly calculate all of the possibilities for your stock position. Note that there is no real breakeven for this strategy because it is a neutral strategy, but the above calculation will tell you how much you need to make up to break, even on the cost of setting up the trade in the first place.

Example 1 - Creating a Collar
Let\'s say you own 100 shares of a stock that trades at $50 per share. To create a collar, you can sell a call option with an exercise price of $60 and buy a put option with an exercise price of $40. The call options sell for $1.20 each while the put options sell for $1.10 each. The position results in a positive credit to your brokerage account of $10!
Now, if the stock moves below $40 you have the ability to sell the stock for $40 with the put option you purchased, no matter how low the stock goes. If the stock rises to $60, however, you may be forced to sell at $60. While this is still a nice profit, you are not able to capitalize on any larger moves to the upside. Many consider this a small price to pay for the peace of mind that comes with full protection.

The dynamics of a collar can vary greatly depending on the situation. Investors have the option of writing zero-cost collars, in which writing calls fully offsets the cost of purchasing the puts (or may even result in a premium). Other investors may wish to increase their profit potential while just seeking disaster insurance, which can be accomplished by "loosening the collar," or writing calls that are more out-of-the-money. In the end, investors must decide whether they wish to preserve their capital or increase their room for profits.

In general, the longer the collar is, the better the risk-reward profile of the entire position will be. The longer-term hedges are cheaper to establish and, therefore, result in a less "risk" (cost) for the same "reward" (strike prices). The problem is that a longer time frame means you are locked in and can only get out by unwinding the position. This becomes a problem because attempting to unwind a position in a bullish time frame will rarely allow you to profit from the end trade. If the position becomes more volatile, however, the risk-reward proposition improves dramatically.

LEAPS Index Collars
Collars are great for hedging against company-specific risk, but what about investors who are looking for a hedge against larger economic downturns? It may be possible to purchase collars on every stock in a portfolio, but it would be expensive and impractical to establish such a position. Instead, investors may consider purchasing a collar against an index that closely mimics their portfolios. But, this is not possible because you cannot write naked calls against such a large number of stocks! Investors may be comforted to know, however, that they can purchase index puts on long-term equity anticipation securities (LEAPS) as a viable alternative.

Example 2 - Creating a LEAP Index Collar
Let\'s say you own a diverse portfolio of stocks with names such as Intel, Microsoft, Exxon Mobil, Wal-Mart, Pfizer and others. To hedge against the market risk of this portfolio, you can simply purchase puts against an index representing all of these stocks. The best choice would likely be the S&P 500 Index (or OEX) because it contains all of these stocks. Just as with stocks, the quantity and strike price of the options depends on the amount of insurance you wish to have on the portfolio.
Now, if the stock market takes a sudden turn and some of your portfolio value is erased, you should theoretically make back nearly that same amount with your put on index LEAPS. The time and price at which you are able to begin collecting, however, depends on the time and price of the index LEAPS strikes you purchased on the puts.

The downside of the LEAPS index puts is that they can only be used on portfolios that already mimic an index. Portfolios holding many unknown small cap or micro cap companies often cannot use this strategy as the movements would be too different. In fact, the strategy could become disastrous if the two do not have any correlation because you could suffer uncovered losses on both ends of the trade!

The Bottom Line
Collars can help investors hedge a portfolio by setting a maximum loss. In some cases, they can even result in a small credit. However, collars can become a problem when your stock starts making a lot of money because your upside is limited by the call options sold to establish the position.

Investors looking to hedge against macroeconomic risk can purchase puts against index LEAPS to make a collar-like position (without the upside limitation) that should (in theory) limit losses in the event of a market downturn. In any case, collars can provide you with great protection in an uncertain market by limiting losses to a set number while enabling you to lock in a healthy and predictable profit.

Related Articles
  1. Stock Analysis

    The Biggest Risks of Investing in Netflix Stock

    Examine the current state of Netflix Inc., and learn about three of the major fundamental risks that the company is currently facing.
  2. Mutual Funds & ETFs

    3 Fixed Income ETFs in the Mining Sector

    Learn about the top three metals and mining exchange-traded funds (ETFs), and explore analyses of their characteristics and how investors can benefit from these ETFs.
  3. Professionals

    Top Stocks to Short, Go Long On to Beat the Market

    A long/short portfolio can help weather a variety of market scenarios. Here's how to put one together.
  4. Mutual Funds & ETFs

    Top 3 Muni California Mutual Funds

    Discover analyses of the top three California municipal bond mutual funds, and learn about their characteristics, historical performance and suitability.
  5. Investing Basics

    What Does Plain Vanilla Mean?

    Plain vanilla is a term used in investing to describe the most basic types of financial instruments.
  6. Mutual Funds & ETFs

    Mutual Funds Are Not FDIC Insured: Here Is Why

    Find out why mutual funds are not insured by the FDIC, including why the FDIC was created and how to minimize your risk with educated mutual fund investments.
  7. Investing

    How to Win More by Losing Less in Today’s Markets

    The further you fall, the harder it is to climb back up. It’s a universal truth that is painfully apparent in the investing world.
  8. Options & Futures

    Pick 401(k) Assets Like A Pro

    Professionals choose the options available to you in your plan, making your decisions easier.
  9. Fundamental Analysis

    Use Options Data To Predict Stock Market Direction

    Options market trading data can provide important insights about the direction of stocks and the overall market. Here’s how to track it.
  10. Mutual Funds & ETFs

    Top 4 Investment Grade Corporate Bonds ETFs

    Discover detailed analysis and information about some of the top exchange-traded funds (ETFs) that offer exposure to the investment-grade corporate bond market.
  1. Why have mutual funds become so popular?

    Mutual funds have become an incredibly popular option for a wide variety of investors. This is primarily due to the automatic ... Read Full Answer >>
  2. Can your car insurance company check your driving record?

    While your auto insurance company cannot pull your full motor vehicle report, or MVR, it does pull a record summary that ... Read Full Answer >>
  3. Can mutual funds invest in options and futures?

    Mutual funds invest in not only stocks and fixed-income securities but also options and futures. There exists a separate ... Read Full Answer >>
  4. Is my IRA/Roth IRA FDIC-Insured?

    The Federal Deposit Insurance Corporation, or FDIC, is a government-run agency that provides protection against losses if ... Read Full Answer >>
  5. Does index trading increase market vulnerability?

    The rise of index trading may increase the overall vulnerability of the stock market due to increased correlations between ... Read Full Answer >>
  6. How does a forward contract differ from a call option?

    Forward contracts and call options are different financial instruments that allow two parties to purchase or sell assets ... Read Full Answer >>

You May Also Like

Hot Definitions
  1. Zero-Sum Game

    A situation in which one person’s gain is equivalent to another’s loss, so that the net change in wealth or benefit is zero. ...
  2. Capitalization Rate

    The rate of return on a real estate investment property based on the income that the property is expected to generate.
  3. Gross Profit

    A company's total revenue (equivalent to total sales) minus the cost of goods sold. Gross profit is the profit a company ...
  4. Revenue

    The amount of money that a company actually receives during a specific period, including discounts and deductions for returned ...
  5. Normal Profit

    An economic condition occurring when the difference between a firm’s total revenue and total cost is equal to zero.
  6. Operating Cost

    Expenses associated with the maintenance and administration of a business on a day-to-day basis.
Trading Center
You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!